ABCD

FUND ACCOUNTING MODULE

Study Manual
2012

DCU
Dublin City University

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Contents

Chapter 1 Introduction....................................................................................................................6
1.1

The Irish Investment Funds Industry

1.2

History of the IFSC and the Irish Funds Industry 8

1.3.

What is a fund? 10

1.4

Why investment funds are created?

1.5

Benefits of a Fund

1.6

Risk/Reward

14

15

16

Chapter 2 Type of Fund Structures...............................................................................................17

2.1

Types of Funds 17

2.2

Specialist/Hybrid Funds 19

2.3

Umbrella Funds19

2.4

Fund of Funds 20

2.5

Master/Feeder Funds

2.6

Hedge Funds

20

21

Chapter 3 - UCITS and Non-UCITS Vehicles.................................................................................24

3.1

UCITS funds

24

3.2

Non-UCITS Funds

29

Chapter 4 - Different approaches to investment decision making....................................................33

4.1

Active v Passive Management 33

4.2

Top-Down v Bottom-Up Portfolio Construction 34

4.3

Growth v Value Stock Selection 34

4.4

Fundamental v Technical Analysis

4.5

Stock Market Timing

35

4.6

Asset Allocation

36

4.7

Group Rotation 36

4.8

Momentum Investing

35

36

Chapter 5 - Overview of various service providers.........................................................................37

5.1

Overview of the Various Parties 37

5.2

Administrator 38

5.3

Transfer Agent 41

5.4

Custodian/Trustee

42

5.5

Investment Manager

47

5.6

Directors to a Fund

47

5.7

Auditors

48
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5.8

Manager/Manager Company

48

Chapter 6 - Introduction to Accounting...........................................................................................50

6.1

The Accounting Equation

6.2

The Ledger System

6.3

Double Entry Bookkeeping

50

52
52

Chapter 7 - Fund Income.................................................................................................................56

7.1

Dividends

56

7.2

Dividend Stock Options 58

7.3

Fixed Income Securities 58

7.4

Interest Bearing or Coupon Bearing Securities

7.5

Smoothing

7.6

Earned Income 68

61

66

Chapter 8 - Fund Expenses..............................................................................................................69

8.1

Introduction to Fund Expenses 69

8.2

Contractual Expenses

8.3

Fixed Expenses 71

8.4

Organisational Expenses

8.5

Performance Fees and Equalisation

8.6

Expense Caps, Waivers and Reimbursements

70
73
74
75

Chapter 9 - Accounting for Investments..........................................................................................76

9.1

Equities

76

9.2

Fixed Interest Securities 79

9.3

Money Market Instruments

9.4

Corporate Actions

9.5

Property

9.6

Accounting for Derivatives

9.7

The Importance of an Accurate Net Asset Value 93

81

83

86
87

Chapter 10 - Irish Stock Exchange..................................................................................................97

10.1

Introduction

97

10.2

Member firms 98

10.3

Rules of the exchange 98

10.4

Insider dealing 101

10.5

Prospectus Regulations 102

Chapter 11 - Money Laundering and Know Your Client.............................................................104

11.1

What is money laundering?

104

11.2

Stages of Money Laundering

105

11.3

What is the Financial Action Task Force (FATF)?

www.fatf-gafi.org 107

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11.4

The Criminal Justice Act 1994 108

11.5

The Money Laundering Guidance Notes 111

Chapter 12 - Data Protection

12.1

Introduction

113

113

12.2 Data Protection Acts

113

Chapter 13 Fund Valuation.........................................................................................................117

13.1

Introduction to Valuations

117

13.2

Valuation

13.3

Pricing Investment Instruments 120

118

Chapter 14 Accounting for Share Capital...................................................................................124

14.1

Accounting for Share Capital

14.2

Distributors

14.3

Dividend Reinvestment 127

14.4

Redemptions/Liquidations

124

126
128

Chapter 15 - The Custodian...........................................................................................................129

15.1

What is Custody?

129

15.2

Domestic & Global Custody

130

15.3

Prime Brokers (Hedge Funds)

133

15.4

Selecting a Custodian

133

15.5

The Cost of Custody

138

15.6

Central Securities Depositories (CSD's) 139

15.7

Driving Forces Impacting on the Custody

142

Chapter 16 - Custody Services......................................................................................................148

16.1

Settlement

148

16.2

Pre Settlement Functions

149

Chapter 17 - Fund Documentation................................................................................................164

17.1

F und Documentation

164

Chapter 18 - Traditional Trading Strategies & Alternative Investment Specific Regulation for Irish
Domiciled Funds...........................................................................................................................170
18.1

Commonly available Fund Products and Asset Classes

170

18.2

Alternative Investment Strategies

18.3

Alternative Investment Strategies : Regulation in Ireland 178

175

Chapter 19 - Fund Restructure Liquidations / Terminations..........................................................188

19.1

Fund Restructures

188

19.2

Voluntary Winding up of Irish UCITS and non-UCITS Schemes - IFIA Guidance Note
194

19.3

Investment Company Liquidation Process

19.4

Administrative Issues on Completion of Wind-Up

198
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19.5

Change of Custodian/Trustee

201

Chapter 20 - Industry Bodies.........................................................................................................203

20.1

IFIA

203

20.2

Data

203

20.3

ALFI

204

20.4

CESR 205

20.5

EFAMA

20.6

NICSA 208

20.7

AlMA 209

207

Chapter 21 - Regulatory Updates..................................................................................................210

21.1

UCITS IV

210

21.2.

Proposed Directive on Alternative

213

21.3

CESR's Advice on Risk Management

214

21.4

Extension to the Regulatory Deadline for Filing of Audited Accounts

215

Chapter 22 - The Role of the Financial Regulator and the Stock Exchange..................................217
22.1

The Role of the Financial Regulator

217

Chapter 23 - Other Jurisdictions and Marketing of Funds.............................................................219

23.1

Luxembourg

219

23.2

The Cayman Islands

23.3

Jersey 222

23.4

Marketing Irish Funds Abroad 223

23.5

Marketing Foreign Funds in Ireland

221

224

Chapter 24 Complex Bonds........................................................................................................228

24.1

Overview of Bond Characteristics

228

24.2

Credit Rating and Credit Rating Agencies

230

24.3

Mortgage-Backed Pass-Through Securities

232

24.4

Junk Bonds including Step Up Bonds and PIK Bonds

236

Chapter 25 Derivatives...............................................................................................................240
25.1

Overview of Derivatives

25.2

Futures 244

25.3

Options 252

25.4

Forwards

267

25.5

Warrants

271

240

Chapter 26 Swaps.......................................................................................................................280
26.1

Introduction

280

26.2

Interest Rate Swaps

281

26.3

Currency Swaps

283

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26.4

Credit Default Swaps

283

26.5

Total Return Swaps

285

26.6

Equity Swaps

26.7

Contract for Difference 286

26.8

Swaptions

286
286

Chapter 27 - Taxation....................................................................................................................288
27.1

Introduction

288

27.2

Taxation of Funds

289

27.3

Taxation of Investors

294

27.4

The EU Taxation Savings Directive

296

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Chapter 1 Introduction
1.1

The Irish Investment Funds Industry

The Republic of Ireland has become one of the most attractive locations for the investment
funds business in recent years. In 1986 the Irish Government announced its intention to
establish an International Financial Services Centre in Dublin with the approval of the
European Community and introduced substantial tax incentives with a view to the successful
development of the IFSC as a location for international financial services.
These incentives were followed in 1989 by a further package of incentives relating to
investment funds in the IFSC. These included UCITS and other investment funds located or
managed by companies operating within the IFSC with the intention of making the IFSC the
most competitive location in Europe for fund management. The Finance Act 2000 extended
the geographical area where Irish-domiciled funds may be administered, from the IFSC to
the entire country.
Most recently, the introduction of Irish-domiciled hedge funds, Common Contractual Funds,
Investment Limited Partnerships and Closed-Ended Investment Companies, has extended the
range of fund vehicles which may be established in Ireland.
Some of the reasons for domiciling a fund in Ireland area as follows:
a)

Generous Tax Incentives

i.

Irish-domiciled investment funds enjoy tax free status, provided that the
investors are non-Irish resident, and that the activities of the fund are carried out
in Ireland by the fund itself or by a management company which has been
licensed by the Department of Finance to operate in Ireland.

ii.

The management company and all fund parties qualify for Irelands 12.5%
corporation tax rate. This compares with rates of 39.5% in the US, 30% in
Germany, 34% in France, and 28% in the UK.

iii.

All Irish fund management companies have the ability to pay interest to nonIrish residents free of withholding tax. Dividend payments and swap payments
are also free of withholding tax.

iv.

Ireland has a network of tax treaties with over 40 countries. This allows for
favourable treatment of profits repatriated from Ireland to many of these
countries. For example, Ireland has a tax treaty with the US, meaning that any
US subsidiaries will pay 12.5% corporation tax on the profits that they make in
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their Irish subsidiary. They may then repatriate this money to the US without
incurring any further tax penalties.
b)

Government Backing
As the funds industry is seen as a way of creating new jobs, the various Irish
regulatory bodies are sensitive to the needs of international fund managers and have a
positive approach to issue which arise in the course of establishing funds in Ireland.

c)

Stock Exchange Listings

The Irish Stock Exchange is recognised worldwide as an attractive centre for the
listing of investment funds. It is seen as flexible, efficient in dealing with applications
for listing and having competitive rates.

d)

Location and Political Environment

Ireland is only one hour from London and shares the same time zone. Both the U.S.
and Asian time zones are covered during a working day.

e)

Infrastructure
Well educated specialist staff are available at relatively competitive rates.
There is excellent availability of multi lingual staff.
English is the language in everyday use throughout Ireland.
There is a stable political environment.
Excellent telecommunications network.

Offshore funds administered in Ireland

In addition to the funds domiciled in the country, Ireland is also a popular administration
centre for offshore funds. An offshore fund is a fund which is marketed in a different
country to the one in which it is authorised. Unlike Ireland, the authorities of jurisdictions
such as the Cayman Islands do not require that the actual administration work of the funds be
performed within their jurisdiction.

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1.2

History of the IFSC and the Irish Funds Industry

October 1986 A report outlining the feasibility of Ireland as an international treasury centre
is presented to the Industrial Development Authority (IDA) by consultant Han Zuurdeeg.
November 1986 The Custom House Docks Development Authority is established.
April 1987 Taoiseach Charles Haughey establishes and IFSC committee.
July 1987 The 1987 Finance Act is passed, legislating for a special 10% rate of Corporation
Tax for IFSC companies, and a 0% tax rate for IFSC funds.
September 1987 The first two companies Gandon and Wang apply for IFSC licenses.
October 1987 The winning design for the Custom House Docks building is chosen.
November 1987 The international stock market crash known as Black Monday occurs, and
initially threatens the IFSC project. Gandon is awarded the first IFSC license.
December 1987 The Industrial Development Authority (IDA) gives the approval for 18
IFSC projects to go forward to the Department of Finances Certification Committee for
licensing.
January 1988 Work on the first IFSC building begins.
November 1988 the Central Bank of Ireland begins publishing draft legislation to establish
a financial services regulatory framework.
June 1989 The UCITS directive comes into effect in Ireland. The 1989 Finance Act is
passed, which exempts UCITS funds from Corporation Tax, Capital Gains Tax, and dividend
withholding tax.
September 1989 The AIG American Equity Trust becomes the first Irish-domiciled UCITS
fund, and the first fund to be listed on the Irish Stock Exchange.
March 1990 The AIB International Centre is completed.
April 1991 The La Touche House building is completed.
June 1991 The IFSC House is completed. The number of authorized IFSC companies
passes the 150 mark.

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June 1992 After intense negotiations, the Government gets permission from the European
Union to extend the IFSC tax regime until 2005.
November 1994 More than 600 IFSC licences have now been issued. The total net asset
value of IFSC-administered collective investment funds now exceeds $14billion.
January 1996 There are now 2,700 people employed by IFSC companies.
July 1997 The Irish Government and the EU reach agreement on a new Irish Corporation
Tax regime, whereby all Irish companies will be subject to a 12.5% rate.
February 1999 A proposed dividend with-holding tax of 24% is introduced, and comes into
law in the Finance Act 2000.
April 2000 The Finance Act 2000 is passed into law.
June 2001 UCITS II funds come into being.
February 2002 the UCITS III Directive is published.
April 2002 Legislation is published which leads to the establishment of the Irish Financial
Services Regulatory Authority (IFSRA).
October 2002 Deutsche Bank sells its Irish funds operations to State Street International.
December 2002 Ireland becomes the first European country to allow the establishment of
retail fund of hedge funds. The value of all Irish-domiciled funds exceeds 300 billion for
the first time.
March 2003 The Finance Bill 2003 is passed, which legislates for the establishment of
Common Contractual Funds that will facilitate pension pooling.
June 2005 Legislation is passed in Ireland allowing the establishment of non-UCITS
registered Common Contractual Funds.
July 2005 The European Savings Directive comes into force. For the Irish Funds Industry,
this means that details of all EU residents who receive dividends and make redemptions from
any Irish-administered bond and money-market funds must be forwarded to the Irish
Revenue Commissioners.

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June 2007 A flurry of consolidation within the industry has been witnessed, with Bank of
New York purchasing Mellon Trust and buying out AIBs 50% share of their joint operation.
State Street acquires Investors Bank and Trust, while Citigroup acquires BISYS Hedge and
Fund Services.
July 2007 Over 7,000 funds are now administered in Ireland, with over $1.5 trillion worth
of funds under administration.
Nov 2007 The Markets in Financial Instruments Directive (MiFID) is transposed into Irish
Law on 1st November.
Feb 2008 The European Commission has published a report on the investment policies of
UCITS and their use of derivatives under UCITS III.
July 2008 The UCITS IV directive has been approved by the European Parliament to be
implemented in 2011.
June 2009 The Government announces that the Irish Financial Services Regulatory
Authority is to be scrapped and replaced by the Central Bank of Ireland Commission, to be
chaired by the Central Bank governor. The Commission will supervise both the stability of
the financial system and individual firms in that system.
October 2010 - The Central Bank Reform Act, 2010, created a new single unitary body the
Central Bank of Ireland - responsible for both central banking and financial regulation. The
new structure replaced the previous related entities, the Central Bank and the Financial
Services Authority of Ireland and the Financial Regulator.

1.3. What is a fund?

A fund is an investment vehicle owned by the investors which enables them to invest on a
pooled or collective basis. Funds are also referred to as collective investment undertakings,
collective investment schemes or pooled investment vehicles.
The most common method of forming a fund is for a promoter, such as a professional
investment manager, to set up a vehicle such as a company or trust and to issue shares in the
Company or units in the trust to people who want to avail of the promoter/investment
managers skills, perhaps because they do not have the time or the expertise to invest their
money.

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The fund is usually traded at a value equal to the Net Asset Value (NAV) per share/unit,
without a premium or discount, which is calculated based on the current market value of the
assets and liabilities of the fund. A fund may not be available for daily trading and as a result
the calculation of NAV may be performed less frequently than daily (e.g., Weekly, monthly,
annually).
The money raised from the sales of the shares or units is then invested on behalf of the fund
by the investment manager. Funds can invest in a huge variety of investments, depending on
how they are set up and what they set out to do. For example, they could invest in property,
in commodities such as gold bullion or oil, in cash, in derivatives etc. However the most
common type of fund is the type that invests predominantly in securities (otherwise known
as stocks and shares).
Investing in securities usually involves an element of risk. There is no guarantee that the
value of a particular investment will go up after you buy it. To limit the risk associated with
investing in securities, the investment manager will take the money raised from the pool of
investors and will invest it across a range of different securities.

This is known as

diversification or spreading of risk. By carefully selecting securities which complement each

other, the investment manager tries to ensure that poor performance on any of the stock
selected will be more than compensated for by the upwards movements of the other stocks,
thus ensuring the fund is never over-exposed to risk of over-investing in one particular stock.
If the investment manager is successful in his investment strategy, the value of the
investments owned by the fund will increase, and so too will the value of the fund itself and
the investors shares in that fund.
By pooling together the assets of a number of investors, all investors benefit from the
economies of scale and diversification of risk afforded by the greater pool of assets. For a
relatively small investment the investor in a fund can get access to a carefully selected and
balanced portfolio of stocks and the skills of an investment manager who constantly
monitors market and currency movements and opportunities. In return for this the investor
pays a management fee to the fund.
Promotor/Investment Manager
The role of the promoter/investment manager is to advise the manager or directors of the
fund on an appropriate investment strategy and then implement it by making and disposing
of investments on behalf of the fund.
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Investment managers are normally subject to restrictions on their powers of investment and
choice of strategies, deriving from the following sources:

(i) Investment Objective

Before a fund is launched, the promoter of the fund will consider carefully what the
nature of the fund is to be, attempting to strike a balance between what will make the
fund attractive to potential investors and what can realistically be attained. The
investment proposition put forward by the promoter will be set out in the funds
prospectus in the form of an investment objective and policies.
The funds investment objective represents the fundamental aim of the fund, the mission
statement as it were, and gives the overall flavor of the investment strategies that will be
pursued by the investment manager. For example, there is usually a trade off in
investing between income and capital growth and the investment objective should
indicate which the investment manager regards as more important. The investment
objective will usually encapsulate the primary type of investment the fund will use equities, bonds, derivatives and so on - and may also indicate the main markets where
the investments will be bought and sold.
Examples of investment objectives are:

To provide long term capital appreciation through investment in European equity

securities

To produce a high level of income yield commensurate with maintaining the value
of the funds capital through investment in a portfolio of US dollar-denominated
income assets.

(ii) Investment Policies

The investment policies of the fund will spell out in detail the way in which the
investment manager will attempt to achieve the investment objective, elaborating on
terms used in the statement of the investment objective, for instance, whether equity
securities includes convertible bonds, how much of the funds cash the investment
manager expects to use as margin deposits and how the investment manager proposes to
assess the creditworthiness of bond issuers.

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(iii) Investment Restrictions

As well as specific investment policies, the prospectus will also contain various
restrictions on the funds powers of investment and with which the investment manager
will have to comply. Typical restrictions include limits on the amount of the fund that
may be invested in any one issuers securities and limits on the amount of leverage the
fund may employ and their purpose is to limit the amount of risk the fund may be
exposed to.
Investment restrictions may be adopted by the manager or the directors of the fund or
may be imposed by the regulatory authorities who have authorised the fund, by a stock
exchange if the fund is listed or by the tax or regulatory authorities of countries in which
the fund is marketed.
(iv) Investment Guidelines
As well as the investment objective, policies and restrictions set out in the prospectus,
the manager or the directors of the fund may require the investment manager to follow
specific guidelines as to the nature of the investments acquired for the fund or their
mode of acquisition, for example, limiting the proportion of the funds non-base
currency assets that may be the subject of currency hedging arrangements.
As well as deciding what investments the fund makes, the investment manager
generally produces periodic reports for circulation to investors, usually with the funds
yearly or half yearly reports, but sometimes more frequently if desirable from a
marketing point of view. These reports will deal with the investment performance of the
fund and should attempt to explain any significant developments, both positive and
negative.
If the investment manager is generating significantly higher returns than expected, it
may be because he is causing the fund to run more risks than it should be.
One important feature of the role of the investment manager is something the
investment manager is not allowed to do, namely not to take control of any of the cash
or assets of the fund. This is the job of the trustee or custodian who will arrange
settlement of any transactions entered into by the investment manager. This division of
labour ensures that there is always a check and balance system in operation and that the

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assets of the fund are in the possession of a custodian, generally a bank or other
financial institution which is substantial in size and strictly regulated.
(v) Benchmarking
The performance of the investment manager and his success in dealing with investments
in the fund is clearly a key component in the ability of the fund to attract new investors
and to retain existing investors. To evaluate the performance of an investment manager,
a system of benchmarking is often adopted. Benchmarking is the process whereby the
performance of the fund is compared to that of a comparable stock index or a range of
similar funds with a view to comparing the performance of the two.
It is usually very difficult to consistently outperform an appropriate benchmark. In
recent years, this has led to a move to set up index tracking funds. Index tracking funds
are what are known as passively managed funds where the investment manager in fact
makes no investment decisions but simply replicates the composition of a benchmark
index (in contrast, active management is where the investment manager makes the
decisions as to where the fund is to be invested independently of any benchmark).

1.4

Why investment funds are created?

Broaden product offerings to existing clients
Broaden client base
Capitalise on existing business strengths:
Distribution
Investment management expertise
Administration (full services operation)
Unique idea for a fund
Investment funds goals are:
To sell shares to investors
To invest the proceeds in a way that provides a good return to investors while at the same
time complying with investment objectives

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Investment funds are designed to meet various investor needs, for example:
Income maximisation (e.g. Preferred shares)
Capital appreciation (e.g. Growth funds)
Balanced (combines both capital appreciation and income maximisation)
High Yield (e.g. High risk junk bonds)
Geographical markets (Global funds, Emerging Market funds)
Speciality funds (invest in a specific industry, commodity or security)
Short-Term v Long-Term
The investment objectives of the fund, how aggressive the fund will be in trying to achieve
growth, the geographical markets to be utilised, and the investment vehicle and techniques
permitted, should all be set out in the funds prospectus.
The investment objectives will determine the type of investment instruments in which the
fund will invest. And there are many different types of investment but they can be
categorised into simple deposits, fixed interest, equities, derivatives, collective investment
schemes and others. They may or may not have an official quotation.

1.5

Benefits of a Fund
Funds as an investment vehicle provide investors with several benefits in comparison to
individual investors:
Diversification: Shareholders investments are, in theory, spread across different securities,
which reduces potential risk.
Professional management: Funds are run by professional money managers. Most will
have proven record of accomplishment and will be assessed on the performance of their
funds.
Economies of scale: A Fund will incur proportionately lower transaction costs and
commissions than individuals. Investment strategy is less restricted due to the availability
of large amounts of cash resources.
Choice and Flexibility:
Convenience:
Regulatory safeguards:
Liquidity and Accessibility:

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1.6

Risk/Reward
The easiest way to distinguish between various categories of investment is through their risk
and the associated potential reward.
Thus simple deposits should, barring unfortunate situations like BCCI and Barings be the
least risky. As a result, the reward is not spectacular in that capital growth may be zero
(negative after inflation is taken into account) and the income is susceptible to changes in
interest rates.
Conversely, equities may have:
Zero capital growth, zero income
Substantial capital growth with continuing income and income growth
The major categories of investment may be split into:
Fixed Income

including Deposits, Bonds and Money Markets

Equities

including Shares

Other

including Property and Derivatives

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Chapter 2 Type of Fund Structures

2.1

Types of Funds
High Risk v Low-Risk Funds
Certain types of investor can take different levels of risk. The more sophisticated type of
investor will frequently want to invest in a fund that is not so concerned with diversification
of risk. In many cases, the higher the risk profile of the fund, the greater the potential returns
for the investor.

On the other hand the smaller investor will not be prepared to put his

retirement savings at risk and will be happier with a long term investment in a low risk fund.
Open-ended v Closed Ended Funds
Funds can be classified according to the manner in which the investor can cash in his
investment. Open-ended funds are funds which allow investors to realise their investment
during the lifetime of the fund by redeeming their shares, receiving back from the fund the
current value of their shares in cash. Closed-ended funds are funds which will not redeem
shares and the only way for investors to cash in their investment is to sell the shares to
someone else or, if the fund has a limited lifespan, to wait until the fund is terminated.
The benefit of a closed-ended vehicle is that the monies invested by shareholders are locked
in for definite period and therefore the investment manager can make investment
management decisions without having to worry about making significant payments to
redeem shares at the request of shareholders.
Investment Company v Unit Trust
Fund can be established using a variety of legal structures, depending on the country in
which the fund is established. In addition, in many countries, there are alternative vehicles
which can be used to achieve the same result, although not strictly speaking classed as fund.
Two of the most common forms of fund used in Europe, both of which are available in
Ireland, are the unit trust and the investment company with variable capital (an investment
company with variable capital is referred to as an open-ended investment company or
OEIC in the U.K. and as a socit dinvestissement capital variable or SICAV on the
Continent).

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Comparison of unit trusts and investment companies

Unit Trusts
A unit trust does not have a separate legal

Investment Company
A company has a separate legal existence.

identity but is represented by the trustee as The assets of the fund belong to the company
legal owner of the assets, on behalf of the

and the investors in the fund own shares in

unitholders who are the beneficiaries of

the company. Custody of the assets is

the trust.

entrusted to an independent custodian who

fulfils many functions corresponding to that
of a trustee of a unit trust.

A unit trust must have a management

An investment company has a board of

company.

directors which performs the same function

as the management company of a unit trust.
There is no requirement to have a
management company although an
investment company will sometimes appoint
a management company for administrative or
other reasons.

A unit trust issues units which represent

A company issues shares which are

an entitlement to a portion of the assets of

equivalent in value to a proportion of the net

the fund.

assets of the company.

A unit trust is governed by either the

A company is governed by the Companies

UCITS regulations or Unit Trusts Act,

Acts, 1963-2006, the UCITS regulations (if a

1990 and the trust deed.

UCITS fund) and its Memorandum and

Articles of Association

A unit trust does not hold an annual

A company must hold an annual general

general meeting.

meeting of shareholders.

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2.2

Specialist/Hybrid Funds
The Financial Regulator (IFSRA) will permit specialist funds to be set up as non-UCITS
funds, and has issued specific notices setting out investment restrictions tailored to such
funds, such as:
Money market funds (investing in cash deposits and short term debt);
Funds of funds (investing in other funds);
Feeder funds (investing only in one other specific fund);
Property funds;
And futures and options funds
The Financial Regulator also allows funds that combine features of different types of
specialist funds, applying the respective notices to that portion of the assets of each such
hybrid fund invested in each specialist category of investments.

2.3

Umbrella Funds
In Ireland, as in most countries, both UCITS and non-UCITS funds can be established as one
structure but with a number of separate compartments, known as sub-funds or classes, each
of which represents a separate group of investors and assets. This is known as an umbrella
structure. In the case of a unit trust, each sub-fund is a separate trust while in the case of a
company, the company will issue different classes of shares each of which relates to different
pools of assets.
The advantage of using an umbrella fund structure is that a number of funds can be
established with different investment policies or fee structures but which have similar
dealing arrangements and other characteristics.
Each umbrella of funds is governed by one main constitutive document (the prospectus).
Once an umbrella fund has been set up, for each new fund it will usually only be necessary
to produce a short supplemental prospectus outlining those features of the new fund which
distinguish it from the other sub-funds already established under the umbrella.

This

considerably speeds up the establishment process as there are fewer and shorter documents
for the parties involved to consider, particularly the regulatory authorities, and it also reduces
costs.

19

ABCD

2.4

Fund of Funds
A fund of funds is a scheme which has as its principal objective making investments in other
funds.

Fund of Funds
Investors

Fund

Fund

Fund

Investors in a fund of funds scheme need to be aware that there is the possibility of investors
suffering costs at both the fund of funds level and the underlying fund level. The Financial
Regulators requirements are designed to prevent such double charging on subscriptions and
to ensure that investors are told of any double charging of management or other fees.

2.5

Master/Feeder Funds
A feeder fund has as its principal objective investment in another single fund (the master
fund). The feeder fund and master fund may be domiciled in different jurisdictions and may
also be set up as different types of structures. For example, a feeder fund might be an Irish
investment company and the master fund a unit trust domiciled in another jurisdiction. For
particular investors, it might be more tax effective to invest into the master fund through the
feeder fund.

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ABCD

Master/Feeder Fund Structure

Investors

Investors

Feeder Fund

Feeder Fund

Master Fund

Assets
2.6

Hedge Funds
Despite the name, a hedge fund has nothing to do with hedging techniques but instead is a
term used to loosely describe a category of fund which is typically established in unregulated
jurisdictions and which employs alternative investment strategies to those employed by more
traditional funds. There are hedge funds of all shapes and sizes, specialising in many
different forms of investment, so that they do not fall easily into any particular category or
description.
The question of how to define a hedge fund can provoke a lengthy discussion among
investment professionals, but while it is difficult to define, it is usually easy to recognise a
hedge fund, as they generally have a number of common characteristics. For example, hedge
funds often use leverage to produce higher returns and take short positions to produce profits
even in falling markets. Strategies which use leveraging and shorting have the potential to
produce large losses and, for this reason, hedge funds have a reputation for carrying a higher
degree of risk than other funds. However, leveraging and shorting do not always materially
increase risk, and there are many hedge funds which use these particular techniques
sparingly, if at all.
Another feature common too many hedge funds is the use of a prime broker. Unlike funds
in more regulated jurisdictions, funds located in unregulated jurisdictions need not
necessarily employ an independent custodian. Instead, they rely on one main broker, through
which they buy and sell securities, to also provide custody facilities as part of its broker

21

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service. To the extent a fund requires to borrow or to take short positions, the prime broker
will also be able to provide financing and lend securities to the fund. As the broker already
has custody of the funds cash and assets, it has security for any cash or securities the fund
has borrowed from it.
Another key element of a hedge fund is the flexibility the investment manager generally
reserves to itself in framing the investment objectives and policies of the fund set out in the
prospectus. Frequently, this will consist only of a general indication of the types of markets
and securities the fund will invest in, with perhaps a description of the investment managers
intended style of management and only a few, very broad investment restrictions, if there are
any at all. In fact, hedge funds are frequently offered solely on the basis of the track record of
the individual manager, who will reserve to himself the ability to follow more or less any
investment style that appeals to him at the time.
In contrast, the more traditional type of fund, particularly those aimed at retail investors, will
usually have a very narrowly defined investment approach with detailed descriptions of the
type of securities and strict limits on concentration and quality, so that the individual
investment professional managing the fund generally has very little opportunity to influence
the style of the fund.
The hedge fund concept originated in the United States, where a hedge fund might typically
begin life as the creation of an investment manager who has gained a reputation and a
following among professional investors, while working for an investment bank or fund
management company. Rather than work for someone else, the investment manager decides
to go out on his own to manage funds for his former clients and contacts, and perhaps even
the former employer.

Provided the fund is restricted to a relatively small number of

substantial investors, the fund will not require authorisation in the United States and will be
exempt from regulation.
Apart from the attraction of not having to share the management fee with anyone else, a
number of well-known hedge fund managers (e.g. George Soros) have scored notable
successes with their funds and have been able to produce very high returns for investors.
Since hedge fund managers also usually charge incentive or performance fees, essentially a
share of the profits generated by the fund, successful managers can become very wealthy.

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Hedge funds escaped their US origins when first US-based managers, and then managers
based elsewhere, began to set up hedge funds in jurisdictions, such as the Cayman Islands,
which offer a similar unregulated environment to that available in the US, but without the
complications created by the US tax system for non-US investors.
Hedge funds have been in existence for some time, the first such fund being established in
the mid-sixties, but until recently, they were regarded as highly speculative investments
suitable only for the very rich private investor who had no outside shareholders or managers
to answer to. However, although not entirely immune to adverse market conditions, a number
of hedge fund managers have proved that they can consistently deliver above market returns.
As the investment industry becomes more familiar and more comfortable with the nature of
investment risk and seeks greater returns than are offered by more conventional funds, hedge
funds are beginning to take on an increasingly significant role in the mainstream investment
industry.
Nevertheless, the general lack of control over the investment manager of a hedge fund and
the lack of regulatory oversight means that investment in such funds still remains largely the
preserve of the wealthy private and institutional investor.

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Chapter 3 - UCITS and Non-UCITS Vehicles

In this chapter we will look at the conduct of business rules applicable to UCITS managers and
other collective investment schemes (non-UCITS) managers.

3.1

UCITS funds
The Financial Regulator has issued a series of UCITS Notices which apply to UCITS which
are either established in the State or established in another EU member state but authorised
to be marketed in the State. These Notices complement the relevant UCITS regulations.
The UCITS manager is required to comply with a number of conduct of business type rules,
in the promotion and sale of units to Irish resident investors:
(i)

Prospectus

Each UCITS must have a simplified and a full prospectus, both of which must be dated and
kept up to date.
The simplified prospectus must be offered to potential investors free of charge, before
investing in the UCITS. The full prospectus must be supplied to investors in UCITS, on
request and free of charge.
The prospectus must contain sufficient information for investors to make an informed
judgment of the UCITS investment and the risks associated with that investment.
Where the value of a UCITS is likely to be highly volatile due to its portfolio composition or
the portfolio management techniques that may be used, a prominent statement drawing
attention to this fact must be included in both the full and simplified prospectuses.

24

ABCD

The simplified prospectus

The simplified prospectus must contain the following information:
(A)

Brief presentation of the UCITS

(i)

Form in law

(ii)

Date of authorisation and date of incorporation where relevant

(iii)

Details of sub-funds in the case of umbrella UCITS

(iv)

Name and address of the management company, if applicable

(v)

The expected period of existence, if applicable

(vi)

Name and address of the trustee

(vii) Name and address of the auditors

(viii) Identity of the financial group promoting the UCITS
(B)

Investment information
(i)

Short definition of the UCITS objectives

(ii)

A description of the UCITS investment policy and a brief assessment of its risk
profile

(iii)

Historical performance, if applicable, and a warning that this is not an indicator

of future performance

(iv)
(C)

(D)

(E)

Profile of the typical investor that the UCITS is designed for

Economic information
(i)

Tax regime

(ii)

Subscription and redemption fees

Commercial information
(i)

How to buy units

(ii)

How to sell units

(iii)

How to switch between sub-funds in the case of umbrella UCITS

(iv)

Distribution policy and dates of distributions of applicable

(v)

How unit prices are published or made available

Additional information
(i)

Statement that, on request, the full prospectus, the annual and half-yearly
reports may be obtained

25

ABCD

(ii)

Name of the Financial Regulator

(iii)

Details of a contract point where additional information may be obtained if

needed

(iv)

Date of publication of the full prospectus

The full prospectus

The full prospectus must contain more detailed information than the simplified prospectus
including such information as:
Brief indications relevant to unitholders of the tax system applicable to the UCITS.
Details of whether deductions are made at source from the income and capital gains paid
by the UCITS to unitholders.
Details of the type and main characteristics of the units
Procedures and conditions for repurchase of redemption of units, including the period
within which redemption proceeds will normally be paid or discharged to investors.
Circumstances in which repurchase or redemption may be temporarily suspended.
Description of the UCITS investment objectives (e.g. capital growth or income) and
investment policy (e.g. specialisation in geographical or industrial sectors).

The

description must be comprehensive and accurate, readily comprehensible to investors and

sufficient to enable investors make an informed judgment on the investment proposed to
them.

The description must include any limitations on that investment policy, and

borrowing powers which may be used in the management of the UCITS.

A statement that the UCITS will, on request, provide supplementary information to
unitholders relating to the risk management methods employed, including the quantitative
limits that are applied and any recent developments in the risk and yield characteristics of
the main categories of investments.
Rules for the valuation of assets.
In the case of umbrella UCITS the charges, if any, applicable to switching of investments
from one sub-fund to another.
The prospectus must state that the authorisation of the UCITS is not an endorsement or
guarantee of the scheme by the Financial Regulator nor is the Financial Regulator
responsible for the contents of the prospectus and must incorporate the following
statement:
The authorisation of this scheme by the Financial Regulator shall not constitute a
warranty as to the performance of the scheme and the Financial Regulator shall not be

26

ABCD

liable for the performance of default of the scheme.

The prospectus must identify, and describe in a comprehensive manner, the risks
applicable to investing in that particular UCITS. In particular the prospectus should make
reference to:
the fact that prices of units may fall as well as rise;
the desirability of consulting a stockbroker or financial adviser about the contents of the
prospectus; and
where relevant, the fact that the difference at any one time between the sale and
repurchase price of units in the UCITS means that the investment should be viewed as
medium to long term.
UCITS with investment objectives which involve a higher than average degree of risk
(e.g. UCITS investing in emerging markets or warrant schemes) must recommend that an
investment in the UCITS should not constitute a substantial proportion of an investment
portfolio and may not be appropriate for all investors. This warning must be inserted and
highlighted at the beginning of the prospectus and the prospectus must contain a full
description of the risks involved.
(ii)

Reports

A UCITS must publish a:

a yearly report, covering a full financial year, and
a half yearly report, covering the first half of the financial year.
The annual report must be prepared within 4 months of the end of the financial period to
which they relate: the time limit for the half yearly report is 2 months from the end of the
period. The annual and half yearly reports must be available to the public at places specified
in the prospectus.
The latest annual report and any subsequent half yearly report must be offered to investors,
along with the simplified prospectus, free of charge before investing in the UCITS.
The annual and half yearly reports must be supplied free of charge to existing investors .

(iii)

Publication of unit prices

The UCITS manager must publish its unit prices each time it issues, sells, repurchases, or
redeems its units, and at least twice a month. In some cases the Financial Regulator may
27

ABCD

allow the prices to be published monthly, instead, on condition that this does not prejudice
the interests of the investors.
(iv)

Change in investment policy

A change to the investment objectives, or a material change to the investment UCITS,
as disclosed in the prospectus, may not be effected without approval on the basis of a
majority of votes cast at general meeting.
Material is taken to mean, although not exclusively; changes which would
significantly alter the asset type, credit quality, borrowing limited or risk profile of the
UCITS.
In the event of a change of investment objectives and/or investment policy, a
reasonable notification period must be provided by the UCITS managers to enable
unitholders encash their units prior to implementation of these changes.

(v)

Advertising UCITS

The advertising of a UCITS is subject to certain restrictions:

it must indicate that a simplified and full prospectus exist and where they may be
obtained or have access to them
where an advertisement contains any forecast or projection, whether of a specific growth
rate or of a specific rate of return, it should make clear the basis upon which that forecast
or projection is made.
Where the fund value is not guaranteed, the advertisement should clearly indicate that the
value of the investment can go down as well as up and that the return will therefore
necessarily be variable.
Where values are guaranteed sufficient detail must be included to give the reader a fair
view of the nature of the guarantee.
All advertisements making claims, whether specific or not, as to anticipated growth in
value of rate of return must include a note, to be given due prominence, to the effect, as
appropriate, that neither past experience nor the current situation are necessarily accurate
guides to the future.
When any advertisement quotes past experience in support of a forecast or projected
growth in the value or rate of return, it must not mislead in relation to present prospects
and should indicate the circumstances in which and the period over which such
28

ABCD

experience has been gained in a way that is fair and representative.

When investors are offered the facility of planned withdrawal from capital as an income
equivalent (e.g. by cashing in units), the advertisement must ensure that the effect of such
withdrawals upon the investment is clearly explained.
Phrases such as tax-free, tax-paid must not be used unless
it is made clear which particular tax(es) and/or duties are involved, and
the advertisement states as clearly as possible what liabilities may arise and by whom
they will be paid.
When the achievement or maintenance of the return claimed or offered for a given
investment is in any way dependent upon the assumed effects of tax or duty, this must be
clearly explained and the advertisement should make it clear that no undertaking can be
given that the fiscal system may not be revised with consequent effect upon the return
offered.
(vi)

Soft commissions agreement

Where managers or administrators of UCITS enter into soft commission arrangements, they
must ensure that:
the broker or counterparty to the arrangement has agreed to provide best execution to the
UCITS;
benefits provided under the arrangement must be those which assist in the provision of
investment services to the UCITS;
there is adequate disclosure in the prospectus and in the periodic reports issued by the
UCITS.

3.2

Non-UCITS Funds
Collective investment schemes, other than UCITS, may be established as :
Unit trusts,
investment companies, or
investment limited partnerships
The Financial Regulator has imposed a series of NU Notices applying to such funds
established in the State and/or marketing to Irish residents.
These NU Notices mirror to a very large extent, the rules for the UCITS Notices already

29

ABCD

referred to above, e.g. requirement to have a prospectus, publication of yearly and half yearly
reports, advertising requirements, etc.

(i)

Professional Investor Funds (PIFs)

Both UCITS and non-UCITS funds are subject to certain investment and borrowing
restrictions in the operation of their investment funds.
However where a fund is marketed only to professional investors these investment and
borrowing restrictions can be dis-applied, provided the minimum investment is 125,000.
The prospectus for such a professional investor fund must indicate, in a prominent position,
that it has been authorised by the Financial Regulator to market solely to professional
investors. It must specify its minimum subscription requirements and add the following:
Accordingly, the requirements of the Financial Regulator which are deemed necessary for
the protection of retail investors, in particular the conditions set down by the Financial
Regulator in relation to investment and leverage, do not apply to the scheme.
Professional Investor Funds are not required to make public the issue and redemption prices
of their units; however, these must be made available to unitholders on request.
The criteria for being considered a professional investor are set out in Annex II to Directive
2004/39/EU on markets in financial instruments, as follows:
Entities which are required to be authorised or regulated to operate in the financial
markets such as:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)

Credit institutions
Investment firms
Other authorised or regulated financial institutions
Insurance companies
Collective investment schemes and management companies of such schemes
Pension funds and management companies of such funds
Commodity and commodity derivatives dealers
Locals
Other institutional investors

Large undertakings meeting two of the following size requirements on a company basis:
Balance sheet total:

20m

30

ABCD

Net turnover:

40m

Own funds

2m

National and regional governments, public bodies that manage public debt, Central
Banks, international and supranational institutions such as the World Bank, the IMF, the
ECB, the EIB and other similar international organisations.
Other institutional investors whose main activity is to invest in financial instruments,
including entities dedicated to the securitisation of assets or other financing transactions.
The above investors are automatically deemed to be professional investors.
Certain individual private investors can opt to be treated as professional investors, provide
they can meet at least two of the following criteria:
the individual has carried out transactions, in significant, in significant size, on the
relevant
the size of the individuals financial instrument portfolio, defined as including cash
deposits and financial instruments exceeds 500,000.
The individual works or has worked in the financial sector for at least one year in a
professional position, which requires knowledge of the transactions or services envisaged.

(ii)

Qualifying Investor Funds (QIFs)

Restrictions on investment objectives and policies and borrowing do not apply to funds
which are marketed solely to qualifying investors and which have a minimum investment of
250,000. However the fund must confirm to the Financial Regulator that it will conform to
the principle of spread investment risk.
The criteria for being a qualifying investor include:
an individual with a minimum net worth (which excludes main residence and household
goods) in excess of 1,250,000.
Any institution (an entity other than a natural person) :
which owns or invests on a discretionary basis at least 25,000,000 or its equivalent in
other currencies or
the beneficial owners of which are qualifying investors in their own right
Qualifying investors must certify in writing that they meet the minimum criteria listed
above and that they are aware of the risk involved in the proposed investment and of the

31

ABCD

fact that inherent in such investments is the potential to lose the entire sum invested.
The prospectus for a Qualifying Investor Fund must indicate, in a prominent position, that a
fund has been authorised by the Financial Regulator for marketing solely to qualifying
investors. It must specify its minimum subscription requirements and add the following:
Accordingly, while this scheme is authorised by the Financial Regulator, the Financial
Regulator has not set any limits or other restrictions on the investment objectives, the
investment policies or on the degree of leverage which may be employed by the scheme.
Qualifying Investor Funds are not required to make public the issue and redemption prices of
their units; however, these must be made available to unit-holders on request.

32

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Chapter 4 - Different approaches to investment decision making

Few issues generate more heated discussion in the investment management circles than do
approaches to investment decision making. Various investment managers considering the
same reality will come to diametrically opposite conclusions. One says you should start the
analyses of emerging markets with the government econometric reports, another says to
ignore these reports. One says to pick common stocks by understanding the fundamentals of
the companies themselves, another says to look at the patterns in the prices of the companys
stock. The list goes on and on.
Below are highlights of a few of the major, commonly encountered approaches, to illustrate
the range of possibilities:

4.1

Active v Passive Management

Can any individual or group of individuals, even professional portfolio managers,
consistently pick securities that are winners? That is the crux of the question that divides the
proponents of active management from those of passive management.

The passive

management schools argument, made most visibly in Burton Malkiels A Random Walk
Down Wall Street, contents that financial markets are so efficient that they make it
impossible for active mangers to consistently outperform market averages.

Passive

managers therefore do not attempt to select individual securities, but rather match the
composition of a segment of the market.

Typically, they attempt to match a major

benchmark index such as the S&P 500 or the Lehman Intermediate Term Government Bond
Index. A passively managed fund or index fund can usually operate at a lower expense ratio
than an actively managed one, because it requires no expenditures on portfolio manager
expertise or research, and it minimizes trading costs.
Active managers attempt to outperform market averages using various investment
techniques, succeeding sometimes and failing sometimes. The allure for the investor, of
course, is the potential of finding a fund whose manager will succeed in outperforming the
market during the period the investor holds the fund. At least one researcher analysing
mutual fund performance has found evidence that (1) some funds consistently outperform the
market; and (2) sophisticated investors direct assets to these funds.
33

(Most academic

ABCD

research, however, tends to support the passive management argument). Actively managed
funds typically have higher expense ratios than index funds, for the reasons cited earlier.
The argument between proponents of active and passive management has continued
unabated for over 20 years. It has prompted both scholarly research and emotional namecalling. Any discussion here will certainly fail to resolve it. An interested reader can easily
find numerous books and articles weighing in on either side of the argument.
Active equity fund managers employ a variety of investment strategies and styles to select
the securities that they believe will outperform the market. They may base their investment
decisions on analysis of the issuing companies, on the state of the financial markets, on
economic trends, on patterns in stock prices, or on combinations of these factors. Active
bond fund managements make their selections according to such factors as interest rate
forecasts, the impact of securities on the maturity time span of the portfolio, and the credit
quality of the issuer. The next few paragraphs describe some of the more prominent methods
active managers take to select securities and construct their portfolios.

4.2

Top-Down v Bottom-Up Portfolio Construction

The top-down manager starts the selection process by identifying general economic trends
and incorporating them into specific market and economic forecasts. He or she then selects
industries and companies that should benefit from those trends. The bottom-up investment
manager considers individual stocks before industry, sector, country and economic factors.
This approach assumes that individual companies can prosper, even when the industry or
economy is not performing well.

4.3

Growth v Value Stock Selection

Growth and value managers represent two fundamentally different approaches to selecting
common stocks. Growth investing attempts to identify companies that promise dramatic
revenue or earnings increases. These companies are typically smaller to medium-sized firms
that are expanding into new or existing markets or developing new products. For the most
part, growth managers dont mind paying higher prices to get the right stocks and taking
more risk to achieve greater return. Growth managers tend to do very well during the
advanced stages of a bull market when investors become more aggressive, pushing the
markets to new highs.

34

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Value investing attempts to identify out-of-favour companies, whose stock has a good
potential to increase in price. Value managers usually have a lower turnover of securities in
their portfolios and assume less risk than growth-orientated managers. They tend to hold
large cash positions at market peaks, when bargains are presumably rarer. In general, value
managers do best when the economy is coming out of a slump and undervalued companies
begin to recover.

4.4

Fundamental v Technical Analysis

Fundamental analysis involves study of the issuing company itself its financial statements
and other quantitative data, plus qualitative assessments of factors such as the companys
management, physical plant, and market presence.

Based on the analysis of these

fundamentals (and different managers have many different ways of going about these
analyses), the manager estimates a value for the companys stock that can be compared to the
current market price. If the manager finds that the current market price is lower than the
computed value, then the stock is considered underpriced and a candidate for buying.
Technical analysis, sometimes called chartists, focus on the details of quantitatively
measurable data on changes in the price of particular stocks or of short interest in the
market, for example. They attempt to find patterns in past behavior that they can use to
match to current patterns and thereby predict future price behavior. In recent years, some
researchers have attempted to employ computer artificial intelligence (most often, neural
nets) to perform these technical analyses, detect patterns and predict price movements.

4.5

Stock Market Timing

Stock market timers (not to be confused with the more controversial market timers of
mutual fund shares) attempt to predict how the prices will trend for individual stocks, stock
groups or the market as a whole. They attempt to determine the right times to buy and sell
by analysing technical factors behind the supply and demand for stocks, such as volume and
price, often using charts or computer programs.

35

ABCD

4.6

Asset Allocation
Asset allocators focus on the anticipated risks and returns of the various assets classes
stocks, bonds and cash given certain assumptions about economic growth, interest rates,
market valuations and other fundamental indicators. They continually adjust their portfolio
composition among the classes and individual security selection is accorded secondary
importance.

The C/Funds, for example, employ an asset allocation strategy, moving

holdings between equity and fixed-income securities according to forecasts of economic

conditions.

4.7

Group Rotation
These managers try to find stock groups that will outperform others at a particular time.
They analyse macroeconomic trends and how a particular economic cycle may unfold and
affect various industrial sectors. (For example, they might examine economic forecasts
involving unemployment and disposable income to make judgments on how companies
producing consumer durable items might fare). They then concentrate their investments in
those sectors that the trend should benefit.

4.8

Momentum Investing
These investors attempt to find and exploit factors that are currently pushing or about to push
a stocks price upward. Some momentum investors focus on the issuing companies their
earnings, cash flow and other statistics, and especially any surprises about these. Other
momentum investors look at stock prices themselves, emphasising the degree to which a
stock is outperforming (or underperforming) the market index or other stocks in its group.
Every mutual fund is free to select a style that its managers believe will best meet the
investment objectives.

The fund is obligated, however, to disclose this choice in the

prospectus, and to adhere to its stated principal investment strategies as it operates.

36

ABCD

Chapter 5 - Overview of various service providers

5.1

Overview of the Various Parties

This illustration outlines the relationship between the various parties to fund.

Transfer Agent
(1)

(10)

Investor

(2)
(9)

Trustee
Investment
Manager
(8)

(3)

(7)

Administrator

Counterparty
(4)

(6)

(5)
Global
Custodian

The trustee views the entire process to ensure it is in compliance with fund and
regulatory restrictions.
1)

Investor decides to deal in Fund and contacts the Transfer Agent.

2)

Transfer Agent informs Investment Manager of Funds Available.

3)

Investment Manager strikes deal on the market based on information received from
Transfer Agent.

4)

Investment Manager advises Custodian of deals placed.

5)

Custodian settles trades on the market.

6&7)

Investment Manager and Custodian advise Fund Accountant of deals placed.

8)

Fund Accountant agrees valuation with Investment Manager.

9)

Net asset value communicated to Transfer Agent.

10)

Shareholder notified of value of investment.

37

ABCD

5.2

Administrator
Some of the management companys responsibilities may be delegated to the Fund
Administrator who is responsible for carrying out periodical valuations of the fund. This can
be daily, weekly or monthly. The main responsibilities of the fund administrator include the
following:
Valuing the assets, calculating and recording the income and expenses, calculating the net
asset value per unit/share, and keeping books of account;
Assisting the auditors in relation to the audit of the financial statements of the Company
and the retention of all essential back-up documents and records for inspection by
auditors and the Central Bank.
Making the necessary filings and ensuring the compliance by the collective investment
undertaking has taken place with applicable regulatory and legal requirements.
Although, the fund administrator is required to liaise closely with the custodian in order that
he has all information necessary to correctly value the fund, they cannot be the same legal
entity.
The day-to-day functions of the administrator include:
(i)

Investment Administration/Fund Accounting

Maintaining the list of investments made by the investment manager on behalf of
the fund and updating the list to take account of purchases and sales of investments
and corporate actions (i.e. Events which have an impact on the value of the funds
investment such as interest or dividends paid on the funds investments or
additional shares or warrants issued through bonus or rights issues on equity
investments).

(ii)

Pricing of Assets/ Calculation of Net Asset Values

Pricing the investments of the fund and producing a valuation of the fund for each
dealing day or other days on which the fund is valued (units or shares in openended funds are issued and redeemed on certain days, known as dealing days). The
dealing days for a particular fund will be decided by the funds promoter when the
fund is established and will be described in the prospectus or placing
memorandum. UCITS funds must have at least two dealing days a month, and
generally other types of Irish open-ended fund will be required by the Financial
Regulator to have a dealing day at least once every quarter.
38

Within these

ABCD

requirements, the promoter is free to choose to have dealing days as frequently or

as seldom as is thought to be appropriate. Depending on the type of fund, dealing
may take place daily, once a week or once a month for example.
The price at which units or shares in the fund will be issued or redeemed will
depend on the valuation of the NAV/share produced by the administrator. The
administrator will generally also publish this NAV/share in newspapers and
through other information services indicated in the prospectus;
(iii) Processing Applications
Receiving and processing applications to buy and redeem units or shares in the
fund (assuming the fund is open-ended) which may come through a distributor or
directly from investors;
(iv) Payments/Credit Control
Ensuring payment is received from applicants for units or shares issued to them,
deducting any commission due to intermediaries and brokers and paying the
proceeds to the custodian or trustee for the benefit of the fund;
Arranging payment of redemption proceeds to redeeming investors;
(v)

Share/Unitholder Register
Maintaining an up to date register of unit or shareholders in the fund and the
number of units or shares to which they are each entitled;

(vi)

Dividends/Distributions
Arranging payment of dividends, income distributions or other general payments to
unitholders or shareholders;

(vii) Fees and Expenses

Arranging payment of fees due to the investment manager and the other service
providers involved in the fund and discharging the other expenses incurred by the
fund (these amounts will normally be paid by the custodian or trustee on the
administrators instructions);
(viii) Interim and Annual Accounts
Maintaining the accounts of the fund and producing yearly and half-yearly
financial statements for circulation to investors (the yearly statements will need to

39

ABCD

be audited and the administrator will be responsible for arranging this with the
funds auditors);
(ix)

Corporate and Secretarial

Acting as secretary of the fund (for funds established as companies), arranging
board meetings, keeping the minutes of these meetings and looking after any
notices or returns that need to be filed in the Companies Registration Office;
Arranging meetings of unitholders or shareholders (remember that companies must
have at least one shareholders meeting or annual general meeting each year) to
discuss and vote on any proposals that may be made from time to time to make
changes to the funds constitutive documentation and any other important issues
affecting the fund or the rights of the investors in the fund;

(x)

Compliance
Ensuring the fund complies with its obligations to the appropriate regulatory
bodies, such as the Financial Regulator and if listed, the Stock Exchange.
Dealing with queries and any other matters, such as procedures to prevent money
laundering, agreed between the administrator and the manager or directors of the
fund.

Some of these functions, such as dealing with applications for units or shares and
redemptions and other unitholder/shareholder matters may be delegated to another service
provider, known as a transfer agent, whose role is discussed in the next section.
Compliance duties, for example ensuring that the investment manager only acquires
investments permitted by the funds investment objectives, policies and restrictions, may in
fact be carried out by the trustee or custodian of the fund, although here a subtle distinction
may be observed between the role of the administrator, whose duties are owed primarily to
the manager or the directors of the fund, and that of the trustee or custodian, who is entrusted
with the specific duty of protecting investors interests.
The administrator can advise the directors or Management Company on compliance issues
but ultimately has to accept their decision as to what action is or is not to be taken. The
trustee/custodian must satisfy itself that if action is taken, it is appropriate, and if not, that the
investors and/or the regulators are informed.

40

ABCD

Other day-to-day operations, such as payment for investments acquired for the fund,
collection of income and dividends paid on the funds investments and delivery of share
certificates and documents of title when investments are sold are the responsibility of the
custodian or trustee.

5.3

Transfer Agent
The responsibilities of a transfer agent include:
Subscriptions and Redemptions: The transfer agent generally assists in the shareholder
servicing requirements of a collective investment undertaking, i.e., collecting the
subscription proceeds and paying out the redemption proceeds. The transfer agent must act
in accordance with the provisions of the Memorandum and Articles of Association/Trust
Deed/Prospectus and may be required to issue a unit/share certificate to the relevant
unitholder/shareholder. Very often, the units/shares will be held in registered form and share
certificates are not issued.
Share Register: The transfer agent will generally maintain the Register in respect of the
collective investment undertaking.

The Register reflects shares subscribed for, shares

redeemed and share balances. The transfer agent periodically prepares and transmits to
shareholders account statements showing the total number of units/shares owned by the
shareholder as of the statement closing date, subscriptions and redemptions of units/shares
by the shareholder during the period covered by the statement and dividends and other
distributions paid to the shareholder during the statement period.
The transfer agent transmits to unitholders/shareholders proxy material and reports and other
information in connection with the collective investment undertaking which is required to be
sent to unitholders/shareholders under relevant legislation. The transfer agent also provides
to the collective investment undertaking and to the administrator periodic reports as
requested, or such periodic reports as are necessary to enable the collective investment
undertaking to comply with relevant regulatory requirements.
Dividend Payments: The transfer agent is responsible for making dividend payments to
investors.
Responding to shareholder queries on an ad hoc basis, including issuing and responding to
all correspondence received relating to the shareholders of the Fund.

41

ABCD

The maintenance of all original documentation received from the shareholders.

5.4

Custodian/Trustee
The Custodian is responsible for the safekeeping of the assets of the Company. They may
also appoint a sub-custodian of the assets but their liability is not affected.
The Trustee of an Irish domiciled investment fund may not be replaced by another trustee
without the approval of the Financial Regulator. The trustee must satisfy the Financial
Regulator that it has adequate and appropriate expertise to effectively carry out its duties.
No single company can act as both Management Company and trustee.

There is an

obligation on both to act independently in the interests of the shareholders to the fund. A
Bank for instance, could establish two separate companies authorised by the Financial
Regulator to provide fund administration and custody/trustee services.
The principal regulatory obligations of a trustee are contained in the Financial Regulator
notices (UCITS and non-UCITS). There is room for confusion in the use of the terms
trustee and custodian. For a unit trust structure a trustee will be appointed and for an
investment company structure, a custodian will be appointed.

Generally, there is no

difference between the functions which will be carried out by a custodian or a trustee and
accordingly the Financial Regulators notices simply refer to the trustee function which is
stated to include the custodian function.

The minimum obligations of the trustee are

contained in the Financial Regulator notices (for UCITS notice no. 4 and for non UCITS
notice no 7). These minimum obligations are very similar for both types of fund and it is
important to realise that the trustee obligations must be carried out in the context of the
trustees general overriding duty to act independently and in the best interests of the
unitholders.
The trustee of an Irish domiciled fund has both trustee and custodial responsibilities. The
trustee responsibilities include:
To ensure that the purchase and redemption of shares is carried out in compliance with
the relevant legislation.
To ensure that the calculation of shares is calculated in accordance with the Memorandum
and Articles of Association.

42

ABCD

To ensure that the income of the fund is applied in accordance with the Memorandum and
Articles of Association.
To carry out the instructions of the management company unless they conflict with the
relevant legislation.
To act as a watchdog for the shareholders of the fund. The Financial Regulator imposes a
duty on the trustee to inquire into the conduct of the management company in its
management of the fund and to report its findings to the shareholders in each financial
year.
The trustee is liable to the management company, the investment company and the
shareholders for any loss suffered by them as a result of its unjustifiable failure to perform its
obligations as a trustee or improper performance of them. This liability to shareholders may
be invoked either directly by the shareholders or indirectly through the management
company.
The custodial responsibilities include:
To ensure that there is legal segregation of non cash assets held under custody and that
these assets are held on a fiduciary basis. In jurisdictions where fiduciary duties are not
recognised, the trustee must ensure that the fund is assured legal entitlement to the assets.
To maintain appropriate internal control systems to ensure that records clearly identify the
nature and amount of all assets under custody, the ownership of each asset and the
location of the documents of title to each asset.
Where a custodian delegates some of its custodial duties by appointing a custodian/subcustodian, it must maintain an appropriate level of supervision and make enquiries from
time to time to confirm that standards are maintained by the custodian. This relationship
is set out in a formal contract between both parties.
A more detailed description of the trustee/custodian obligations are as follows:
Safekeeping of the funds assets.
The funds assets must be placed with a trustee for safekeeping.

The trustee is

responsible for the physical safekeeping of the assets and the everyday administration of
these assets. The trustee holds the assets on behalf of the fund and not for its own benefit.
The term assets are defined broadly to include dividends and interest as well as the
securities of the fund (equities, bonds). The trustee must be satisfied that controls are in
43

ABCD

place in the custodian (or that the sub-custodian, where one is appointed, has appropriate
controls in place) to ensure that assets of the fund are in safekeeping. This is one of the
main obligations of the trustee and the duty that most people are familiar with.
The trustee must ensure that the sale, issue, repurchase and cancellation of units in
the fund is carried out in accordance with the regulations and the fund
documentation.
The trustee must ensure that the sale, issue, repurchase, redemption and cancellation of
units are carried out in accordance with the regulations and the fund documentation.
The records of units issued and redeemed will be maintained by the transfer agent who
has been contracted to carry out this function on behalf of the fund. This could be the
management company or a third party transfer agent. The use of the word ensure in the
Financial Regulator notices should not be interpreted as a guarantee given by the trustee
that every share activity is carried out correctly. Rather it should be interpreted that the
trustee is responsible for ensuring that adequate controls are in place with the relevant
transfer agent. The trustee is expected to monitor the controls periodically. Normally this
will be interpreted to mean visiting the transfer agents office.
The trustee must ensure that the value of units is calculated in accordance with the
fund documentation and the regulations on a periodic basis and to inspect the
procedures and controls employed by the transfer agent.
The calculation of the net asset value of the fund is usually carried out by the
management company or delegated to an administrator. Again, the word ensure is
interpreted to mean that the trustee should review the administrators controls and
procedures to ensure that it is in a position to correctly complete the function which it has
been contracted to carry out. The word ensure does not mean that the trustee will
automatically be responsible if there is an error in a NAV calculation but that the trustee
will be required to investigate the administrators procedures and controls for producing
the NAV on a periodic basis.
The trustee must carry out the instructions of the management company unless they
conflict with the regulations or the fund documentation.

44

ABCD

The management companys instructions may be received by fax, electronically, telex etc.
The trustee must ensure that he has a way of identifying that the instructions are indeed
from the management company e.g. Authorised signatory list.
The trustee will review the constitutional documentation of the fund and identify the
restrictions placed on the fund in addition to the regulations. Once the investment
restrictions for the fund are documented, the trustee should review periodically the
instructions and valuations to ensure that the management companys instructions are in
accordance with the regulations and the fund documentation.
Once again the trustee should review the management companys controls and procedures
to ensure that the management company does not instruct the custodian of a trade in
breach of the documentation of the fund. An example of such a breach would be where a
fund which can invest only in European companies sends the trustee an instruction to
invest in Russia.
The trustee must ensure that in transactions involving a funds assets, consideration
is remitted to the fund within acceptable time limits in the market place.
The trustee must ensure that in transactions involving the funds assets i.e. Delivery of
securities that the fund sells or payment of money for the purchase of securities, the
consideration is received within the usual time limits prevailing in the country where the
transaction involved took place. Where consideration is not remitted within acceptable
market time frames, the fund may be at risk of non-delivery or of being out of pocket
until the cash or assets are delivered. The word ensure is interpreted to mean that the
trustee will satisfy itself that the controls and procedures in the custodians office are
sufficient to ensure that the consideration is remitted to the fund within acceptable time
limits.
The trustee must ensure that a funds income is applied in accordance with the
regulations and the fund documentation.
The fund manager can be responsible for this or it can be delegated to a third party
transfer agent.
Again the word ensure does not mean that the trustee must guarantee that each dividend
is calculated correctly instead, the trustee must satisfy itself that the controls and

45

ABCD

procedures in the transfer agents office are adequate to discharge this function. It may
periodically review their procedures to ensure that the transfer agent controls are being
adhered to and operating effectively.
The trustee must enquire into the conduct of the management company in each
accounting period and report thereon to the unitholders.
The trustee will provide an annual report for inclusion in the funds annual report. This is
the accumulation of the trustees work over the year. It is important in that it is possibly
the only direct contact the trustee will have with the actual unitholders of the fund. Most
of the unitholders contact will be with the management company or other delegated third
party providers.
The trustee report states whether or not, in the trustees opinion the fund has been
managed in accordance with the limitations imposed on the investment and borrowing
powers of the fund as provided in the fund documentation and relevant regulation; and
otherwise in accordance with the fund documentation and the regulation.
If the management company or investment company does not comply with (i) or (ii)
above, the trustee must state why this is the case and outline the steps which the trustee
has taken to rectify the situation.
The trustee must ensure that the terms and conditions of any agreement entered into
by a fund for the purposes of efficient portfolio management are observed.
It is important to note that this obligation only applies to non-UCITS funds. The word
ensure means that the trustee must satisfy itself that the management company has
sufficient controls and procedures to enable it to ensure that the terms and conditions of
efficient portfolio management agreements are observed.
The Standard of Care Required of the Trustee
There are different rules for the standard of care required of trustees for UCITS and nonUCITS funds, as a result of differing approaches to the implementation of the UCITS
directive. In the case of a UCITS fund, the Financial Regulator requires the trustee to
undertake to be liable to the management company, investment company and unitholders for
any loss suffered as a result of the trustees unjustifiable failure to perform its obligations or
its improper performance of them. For a non-UCITS fund, the trustee will be liable for
fraud, negligence, willful default, bad faith or reckless disregard of its obligations.
46

ABCD

The relevant statements must appear in the trust deed of a unit trust or in the custodian
agreement for an investment company or an investment limited partnership. The unit holders
may enforce this liability either directly (i.e. Sue the trustee themselves) or indirectly though
the management company. This will depend on the legal nature of the relationship between
the trustee, Management Company and the unitholder who suffered the loss.
The liability of a trustee will not be affected by the fact that it has entrusted to a third party
some or all of the assets in its safe-keeping. Clearly this obligation will be highly relevant as
it will be usual for the trustee to appoint sub-custodians in the different jurisdictions where
the funds assets are located. These sub-custodians act as agents of the custodian and hold
the assets of the fund on its behalf.
In order to discharge the trustees responsibility, the trustee must exercise care and diligence
in choosing and appointing its sub-custodians so as to ensure that the sub-custodian has and
maintains the expertise, competence and standing appropriate to discharge the
responsibilities concerned. The trustee must maintain an appropriate level of supervision
over the sub-custodian and make appropriate enquiries from time to time to confirm that the
obligations of the sub-custodian continue to be competently discharged.

5.5

Investment Manager
The investment manager/advisor makes the discretionary fund management decisions with
regard to the purchasing and selling of the underlying assets of the fund.

Investment

management and advisory activities are not required to be carried out in Ireland. The
administrator will reflect these activities in the valuations of the fund.

The Financial

Regulator imposes certain investment policies and restrictions which the investment advisor
must adhere to.

5.6

Directors to a Fund
The appointment of directors to management companies, administration companies and
trustee/custodian companies requires the Financial Regulators approval.

If a director

resigns from any of these companies, the Financial Regulator must be informed.

47

ABCD

The board of directors of an investment company, Management Company or administration

company must not have directors in common with the directors of the trustee of the
investment fund. The trustee has independent functions and duties.
The Financial Regulator requires that at least two of the directors of any of these companies
must be Irish Residents.

5.7

Auditors
The auditor of must be qualified in accordance with the provisions of the Irish Companies
Acts and in addition to the normal auditing duties, has specific duties imposed on him under
the UCITS regulations concerning the auditing of the accounts of a UCITS. He also has a
direct obligation to report to the Financial Regulator in certain circumstances.

5.8

Manager/Manager Company
A unit trust scheme is a non-operational vehicle and its day to day operations are conducted
by the management company and the trustee. A variable capital company may also delegate
its management functions to a management company for an annual fee.
The management company provides the effective control and management to a collective
investment undertaking. Notwithstanding the overall responsibility of the custodian / trustee,
the management company generally has the following duties which may be delegated:
Issues the prospectus which is approved by the Financial Regulator.
Appoints a distributor to raise funds and vests those funds in the trustee.
Appoints an investment adviser.
Administers the subscription and redemption of units/shares.
Values the assets, calculates the net asset value per unit/share and keeps books of account.
Prepares the annual report and accounts.
Keeps the prospectus up to date.
Markets the units.
Makes necessary filings and ensures compliance by the collective investment undertaking
with applicable regulatory and legal requirements.

48

ABCD

A management company will usually in turn delegate certain of its functions to third parties
and any application for authorisation as a collective investment undertaking must include
information concerning the name of any entity which has been contracted by the
management company to carry out its work together with copies of any relevant agreements.
Sufficient information concerning any such third party must be supplied to enable the
Financial Regulator to be satisfied as to its expertise, integrity and adequacy of financial
resources.
As the management company must ensure compliance by the collective investment
undertaking with applicable regulatory and legal requirements, the management company
will monitor the performance of the various service providers to the collective investment
undertaking.
In Ireland, a management company may be incorporated as a private limited company,
having financial resources of Eur125,000 (or the equivalent in another currency), or three
months expenditure, whichever is greater. A minimum of two directors must be Irish
residents.
Appointments to the office of director of the management company require the prior
approval of the Financial Regulator. In addition, departures from or changes in the office of
director must be notified to the Financial Regulator immediately.
The board of directors of the management company must not have directors in common with
the board of directors of the trustee of the collective investment undertaking for which it acts.
The management company is obliged to satisfy the Financial Regulator on a continuing basis
that it has sufficient management resources to effectively conduct its business. In addition,
its directors and managers should be persons of integrity and have an appropriate level of
knowledge and experience. The Financial Regulator will hold review meetings with the
management company from time to time.

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ABCD

Chapter 6 - Introduction to Accounting

Accounting is often said to be the language of business. It is used in the business world to
describe the transactions entered into by all types of organisations. Accounting terms and
ideas are therefore used by people associated with business, whether they are managers,
owners, investors, bankers, lawyers or accountants.
The actual record-making phase of accounting is usually called book-keeping. However,
accounting extends far beyond the actual making of records. Accounting is concerned with
the use to which these records are put, their analysis and interpretation. An accountant
should be concerned with more than the record-making phase. In particular an accountant
should be interested in the relationship between the financial results and the events with
created them. Investors and others will use financial statements produced by a business, to
influence their relationships with the business accordingly.
There are two main questions that the managers or owners of a business want to know: first,
whether or not the business is operating at a profit; second, whether or not the business will
be able to meet its commitments thus avoiding closure due to lack of funds. Both of these
questions should be answered by the use of the companys financial statements.
There are various accountancy bodies in Ireland but the two main ones are the Institute of
Chartered Accountants in Ireland (ICAI) and the Chartered Association of Certified
Accountants (ACCA). Most accountancy firms carry out statutory audits but they also
provide many other services. These include corporate taxation, insolvency, corporate finance,
personal taxation and other advisory type services.

6.1

The Accounting Equation

Financial accounting is based on the accounting equation. For a business to operate it needs
resources, and these resources have had to be supplied to the business by someone. The
resources possessed by the business are known as Assets, and obviously some of these
resources will have been supplied by the owner of the business. The total amount supplied
by the owner is known as Capital.

50

ABCD

In the startup situation when the owner is the only one who has supplied the assets then the
following equation would hold true:
Assets = Capital
However sometimes, some of the assets will have been provided by someone other than the
owner. It is normal for businesses to source funds externally. The indebtedness of the
business for these resources is known as Liabilities. The equation can now be expressed as:
Assets = Capital + Liabilities
It can be seen that the two sides of the equation will have the same totals. This is because we
are dealing with the same thing from two different points of view.
Resources: What are they =

Resources: Who supplied them

(Assets)

(Liabilities)

It is a fact that the totals of each side will always equal one another, and this will always be
true no matter how many transactions are entered into. The actual assets, capital and
liabilities may change, but it will always hold true that the total of the assets will equal to the
total of the liabilities and capital.
Assets consist of property of all kinds, such as buildings, machinery, stocks of goods and
motor vehicles. In addition assets include benefits such as debts owing by customers and the
amount of money in the bank account. For a mutual fund assets would include equity and
fixed income securities.
Liabilities consist of money owing for goods supplied to the firm, expenses incurred by it
and for loans made to the business.
Capital is often called the owners equity or net worth. It initially comprises of the amounts
invested by shareholders, but will also include reserves, which are the profits earned to date
and not yet paid out to shareholders in the form of dividends. Capital also includes the long
term liabilities of the business such as bank loans.

51

ABCD

Example
Mr X is setting up a new business and invests Eur4,600 cash into it on 1 January 2005. The
amount invested referred to as capital is the amount owed by the business to Mr X. At 1
January 2005 the accounting equation would be:
Assets
Eur4,600 (Cash)

6.2

Capital plus Liabilities

Eur4,600 + Eur0

The Ledger System

Ledgers are another name for some of the books of account of a business. The sales ledger
contains lists of amounts due from customers; there will also be a corresponding purchases
ledger. These are generally termed personal ledgers, because they deal with debts to and
from persons/entities. There are also nominal ledgers that deal with accounts that are neither
real nor personal, for example interest costs or depreciation charges. However, the majority
of computerised investment systems have just one general ledger that comprises all the
accounts of the fund or company, and includes the cash book.

6.3

Double Entry Bookkeeping

As we have seen, since the total of liabilities plus capital is always equal to total assets, any
transaction which changes the amount of total assets must also change the total liabilities
plus capital, and vice versa. Alternatively, a transaction might use up assets of a certain
value to obtain other assets of the same value. For example, if a business pays Eur150 in
cash for some goods, its total assets will be unchanged, because as the amount of cash falls
by Eur150 the value of goods in stock rises by the same amount.
Ledger accounts, with their debt and credit side, are kept in a way which allows the two-side
nature of business transactions to be recorded.

This system of accounting was firsts

developed in Venice in 1494 AD and it is known as the double entry system of

bookkeeping, so called because every transaction is recorded twice in the accounts. This is
sometimes referred to as the concept of duality.
The basic rule which must always be observed is that every financial transaction gives rise to
two accounting entries, one a debit and the other a credit. A debit entry means the business
owns and a credit entry means the business owes. The total value of debt entries in the
general ledger is therefore always equal at any time to the total value of credit entries.
52

ABCD

Which account receives the credit entry and which receives the debit depends on the nature
of the transaction.
(a)

An increase in an expense (e.g. a payment of audit fees) or an increase in an asset (e.g.

a purchase of a financial instrument) is a debit entry.

(b)

An increase in income (e.g. a receipt of a dividend) or an increase in a liability (e.g.

buying goods on credit) is a credit entry.

(c)

A decrease in an asset (e.g. making a cash payment) is a credit entry.

(d)

A decrease in a liability (e.g. paying a creditor) is a debit entry.

A good starting point is the cash amount, i.e. the general ledger account in which receipts
and payments of cash are recorded. The rule to remember about the cash account is as
follows:
(a)

A cash payment is a credit entry in the cash account. This is because it is a decrease in
the cash asset. Cash may be paid out, for example, to pay an expense (such as light &
heat) or to purchase an asset (such as a computer). The matching debit entry is
therefore made in the appropriate expense account or asset account.

(b)

A cash receipt is a debit entry in the cash account. Here the asset is increasing. Cash
might be received, for example, by a retailer who makes a cash sale.

The

corresponding credit entry would then be made in the sales account.

Going back to the accounting equation:
Assets

Capital plus

Liabilities

To increase each item:

Debit

Credit

Credit

To decrease each item:

Credit

Debit

Debit

Example
a)

Purchase of a security for cash for Eur2,000

b)

Payment of the annual audit fee Eur1,000

c)

Sale of a bond for eur7,000 (assuming no gain or loss generated)

a)

The two sides of the transaction area:

(i)

Assets in this case Securities at Cost increases by Eur2,000 (debit entry to

the Securities at Cost Account)
53

ABCD

(ii)

Cash is paid (credit entry to the cash account)

Dr

Securities at Cost
Cr

b)

Cash

Eur2,000

The two sides of the transaction are:

(i)

Audit expense increases by Eur1,000 (debit entry to the audit account)

(ii)

Cash is paid (credit entry to the cash account)

Dr

Audit Fee
Cr

c)

Eur2,000

Eur1,000

Cash

Eur1,000

The two sides of the transaction are:

(i)

Cash is received (debit entry to the cash account)

(ii)

Assets Securities at cost decrease by Eur7,000 (credit to the Securities at

Cost Account)
Dr

Cash
CR

Eur7,000
Securities at cost

Eur7,000

Not all transactions are settled immediately in cash. A business might purchase goods or
fixed assets from its suppliers on credit terms, so that the suppliers would be creditors of the
business until settlement was made in cash. Equally, the business might grant credit terms to
its customers who would then be debtors of the business. Clearly no entries can be made in
the cash accounts when a credit transaction occurs, because initially no cash has been
received or paid. We must therefore use debtors and creditors accounts. When a business
acquires goods or services on credit, the credit entry is made in an account designated
creditors instead of in the cash account. The debit entry is made in the appropriate expense
or asset account, exactly as in the case of cash transactions. Similarly, when a sale is made
to a credit customer the entries made are a debit to the total debtors account (instead of cash
account) and a credit to sales account.
Example
a)

The business purchases a scanner on credit for Eur700

b)

The business sells goods on credit for Eur450

a)

The two sides of the transaction are:

(i)

Assets scanner increases by Eur700 (a debit entry to the assets account)

54

ABCD

(ii)

The amount owed to creditors increases by Eur700 (a credit entry to the

creditors account)
Dr

Scanner
Cr

b)

Eur700
Creditors

Eur700

The two sides of the transaction are:

(i)

The amount owed by debtors increases (debit entry to the debtors account)

(ii)

The sales account increases by 450 (credit entry to the sales account)
Dr

Debtors
Cr

Eur450
Sales

Eur450

When these transactions are settled (i.e. when the cash is physically paid for the scanner or
received for the goods sold) the following transactions occur.
a)

Payment of Eur700 for the scanner:

(i)

The amount owing to creditors is reduced (debit entry in the creditors account)

(ii)

Cash is paid (a credit entry to the cash account)

Dr

Creditors
Cr

b)

Eur700

Cash

Eur700

Receipt of sales proceeds of Eur450 from customer:

(i)

Cash is received (debit entry to the cash account)

(ii)

The amount due from debtor is reduced (credit entry to the debtors account)
Dr

Cash
Cr

Eur450
Debtors

55

Eur450

ABCD

Chapter 7 - Fund Income

How do funds provide for income and expenses? Like any other company, an investment
company generates income and expenses as it operates.

The policies determining the

reflection of income are primarily dictated by the accounting concept of the accrual which
states that:
Income and Expenses are recognised as they are earned or incurred and dealt with in the
accounts of the period to which they relate.
This concept is of particular importance in the calculation of Net Asset Value per share. The
use of accruals enables funds to allow unitholders subscribe and redeem while proportionally
benefiting from the income of the fund without having to retain their investment until they
receive monies. Accruing for expenses ensures that the operational expenses of the fund are
allocated fairly over the shareholder base.
The policies used to record income and expenses can also have a material effect on the NAV
of the fund. It is of paramount importance that an administrator is entirely familiar with the
income entitlements of the securities in their portfolio and the expenses allocation policies of
the fund; ignorance of or misinterpretation of this information can materially affect the value
of the funds shareholders wealth. The sources of income we are going to look at include
dividends, interest on fixed income securities and coupon bearing securities.

7.1

Dividends
Stock-holding confers on the holder of the stock a proportional entitlement to the distributed
profits of a company. The distributed profit is known as a dividend. The company decides
what portion of profit will be distributed and what portion will be retained and then declares
the amount publicly. A company may or may not declare a dividend annually.
Entitlement to a dividend is dependent on the tranche of stock held by the shareholder.
Ordinary shareholders are the last group entitled to a share of the companys profits. All
obligations to the other holders of capital in the company must be satisfied before the
ordinary shareholder can receive a dividend. The amount of dividend declared varies on
each occasion.

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ABCD

However companies generally like to maintain the same level of dividend and any significant
variances in the total value of dividends declared on a particular stock would merit
investigation by the fund administrator.
Preference shareholders are entitled to a fixed dividend on an annual basis. The rate at which
the preference shareholder is entitled to dividend is usually included in the stock description
e.g. ABC Company 6% Preference Shares. Cumulative preference shares entitle the holder
to receive an annual preference dividend for each year the stock has been held. If a company
cannot pay a dividend in a particular year, the cumulative preference shareholders must
receive their entitlement from prior periods before any other shareholders can receive
dividends. The following grid summaries the entitlements of the different tranches.

Bonds

Preferred Stock

Common Stock

Claim on Income
Priority
Amount

First
Fixed

Second
Fixed

Last
Residual

Claim on Assets
Priority
Amount

First
Fixed

First
Fixed

Last
Residual

Mandatory

Discretionary

Discretionary

Mandatory or Discretionary
Claim

Companies declare dividends on an annual, interim and final basis.

From the fund

administrators perspective, the processing of each type of these dividends is the same.
The company declares the dividend on the announcement date
ABC company declares Annual Dividend
Announcement Date:

21/04/05

Ex-Date:

31/04/05

Pay-Date:

25/05/05

Record Date:

10/05/05

Dividend Rate:

4.0

Withholding Tax:

20%

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ABCD

Assuming the shares are denominated in sterling and the fund has a holding of 200,000
shares the dividend entitlement will be as follows:
Gross Dividend

200,000 x 4 =

8,000

Withholding Tax

8,000 x 20% =

1,600

Net Dividend

6,400

A portion of the tax in an offshore fund might be reclaimable. In that case a further provision
against income would be made to reclaim the amount of tax outstanding.
The receivable would be recorded as ex-date and the net money recorded against cash on pay
date.

7.2

Dividend Stock Options

Companies may give the shareholder the option to choose between a cash dividend or the
receipt of the equivalent value in stock. In the case that an alternative between cash and
stock is offered to the shareholder, the dividend receivable is recorded as above. If the fund
elects to receive stock in lieu of cash the opportunity cost (i.e. the net cash dividend
foregone) is allocated as the cost of the new shares.
Where no option to receive cash is given to the shareholder the stock dividend is brought
onto the valuation at no cost.

7.3

Fixed Income Securities

Fixed income securities are financial instruments that promise income and repayment of
principle in pre-specified amounts and at pre-specified times. There are many different types
of fixed income securities, but the way in which each of the different types are accounted for
is generally the same and relatively simple if the financial behavior of the security is
understood.
Discount vs Fixed Income
Most fixed income securities that you will encounter can be classified as either Discount
Securities or Interest Bearing Securities.

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ABCD

A discount security is an instrument (i.e. a short term debt instrument) which is bought at a
price lower than the face value and has no coupon associated with it. Examples of discounted
securities are zero coupon bonds and commercial papers. These securities are issued at a
discount and redeemed at maturity for full face value.
The difference between the face amount and the amount paid is the discount and constitutes
the interest and should be treated as income of the fund. The typical example of a discount
security is the US Treasury Bill (T-Bill). Another example is a commercial paper. All
discount securities are accounted for in a similar manner.
Example of a Discount or Zero Coupon Security.
A US T-Bill 15/12/2005 is purchased by a fund on 15/09/2005
Fund:
Transaction:
Security Name:
Cusip/Sedol:
Trade Date:
Settle Date:
Settlement Currency:
Total Quantity:
Price:
Gross Consideration:
Accrued Income:
Net Consideration:

ABC Fund
Buy
US T-Bill 15/12/2005
312537H26
13/09/05
15/09/05
USD
80,000,000
98.8347
79,067,755.56
--79,067,755.56

The fund has an investment on September 15 which will be worth US$80,000,000 on

December 15. The difference between the purchase price and the value at maturity is known
as the discount. In effect the discount is the return on the investment.
Maturity Value

80,000,000.00

Discounted Purchase Price

79,067,755.56

Total Discount

932,244.44

The principal paid out is the present value of 80 million USD in ninety-one days from
settlement date at current discounted rates.

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ABCD

Discounted securities are held on the valuation using the accreted value method.

An

accounting convention in the US for money market securities called the 60 day rule states
that it is acceptable to value discounted money market securities with a maturity of 60 days
or less at accreted cost if the Board of Directors of the fund determines in good faith that
amortised cost approximates the fair value of debt securities purchased with remaining
maturities of sixty days or less. In simply terms discounted securities with a maturity of
sixty days or less need not be marked to the market but can be carried on the valuation at a
calculated cost called the accreted cost.
The simple accreted cost of the security in our example can be calculated as follows:
Total Discount:

Maturity Value less Discounted Cost = Total Discount

80,000,000 79,067,755.56 = 932,244.44

Days to Maturity:

Maturity Date less Settlement Date

15/12/2005 less 15/09/2005 in actual days = 91

Daily Accretion Factor:

Total Discount/Number of Days to Maturity

932,244.44/91 = 10,244.44

For example, the total simple accreted cost of our T-Bill as at 30/09/2005 would be equal to
the number of actual days from settlement to valuation date times the daily accretion factor.
Number of actual days from 15/09/2005 to 30/09/2005 = 16 days
Daily accretion to 30/09/2005 = 16 x 10,244.44 = 163,911.11
Accreted cost as at 30/09/2005 = Total Accretion to Date + Discounted Cost = 163,911.11 +
79,067,755.56 = 79,231,666.67
Therefore as at September 30 the valuation would show
Security
Description

No of
Shares

US T-Bill
15/12/2005

80,000,000

Cost

Market
Value

Unrealised
Gain/Loss

79,067,755.56

79,231,666.67

The income account would reflect accretion of $163,911.11 for the period.

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ABCD

Using the accreted cost method complies with the accrual concept. The alternative to
accretion would be to mark the security to market on a daily basis. The effect on the NAV of
the fund would be substantially the same in times of interest rate stability as the accreted cost
usually reflects the market value of the security. However prior to maturity the income effect
would be recognised as an unrealised capital gain and at maturity as a realised capital gain.
This treatment, though not material to the NAV, is generally regarded as incorrect as it
understates the income of a fund.
Money Market and Accretion
The Accretion policy is of particular importance in Money Market Funds. It is the aim of
Money Market funds to offer the investor an alternative to placing their cash on deposit with
financial institutions. Instead the Money Market fund invests in a portfolio of short term
securities hoping to give the shareholder the guarantee of capital preservation coupled with a
higher return than would be generally available from overnight or longer deposit rates.
Normally money market funds quote a dollar ( or Eur) NAV with a specific yield. The
maintenance of the dollar NAV is possible because the board of directors of the fund have
determined that all short term securities in the fund will be maintained at accreted or
amortised cost. Amortisation is the allocation of premium against income over the life of a
security. Amortisation ensures that there is no capital gain on maturity. In effect it is the
opposite of Accretion.
Interest rates are unlikely to remain stable in the long run and there may come a time when
accreted/amortised cost does not properly approximate the realisable market value of short
term securities.

Money Market funds are therefore obliged to mark their portfolio of

securities to the market to ensure that there is not a fifty basis point difference between the
realisable market value and the accreted/amortised cost of their investment. As long as the
variance is less than fifty basis points the $1.00 NAV is acceptable. If the variance is greater
than fifty basis points, unitholders in the fund are likely to be penalised by not receiving the
full value of their investment (if the variance is positive) or have the value of their position
overstated (if the variance is negative).

7.4

Interest Bearing or Coupon Bearing Securities

An interest bearing security is one which is issued with a fixed face value, matures at a
specified date and carries a specific rate of interest that the insurer promises to pay the holder
of the security. If the interest rate specified on the security is different from the market

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ABCD

interest rate for securities in the same risk class there will be a difference between the face
value and market value which will be treated either as a discount or as a premium. All
interest bearing securities (e.g. treasury bonds, treasury notes, corporate bonds etc.) are
accounted for in a similar manner.
If the interest rate specified on the security is less than the market interest rate then security
will sell at a discount (i.e. market value will be less than the face value). If the security is a
bond or a note it will then be referred to as a discount bond or a discount note. (This should
not be confused with the discount securities described above).
The security will sell at a premium if the interest rate specified is more than the market
interest rate (i.e. market value will be more than the face value).
A typical bond is a promise of fixed interest payments every six months or annually and a
final payment at the maturity of the bond of the face value. The present values of all these
payments can be added to give the present value of the bond. If the discount rate is the
market rate, it gives the market value of the bond.
From the fund administrators perspective there are a number of key pieces of information
which are required in order to properly reflect the income stream from an interest bearing
security. These are outlined in the grid below:

Face Value

The maturity value of the security. This represents the principal amount
borrowed by the issuer on which regular interest payments must be
made.

Maturity Date

The date of the final interest payment and the date the face value is
returned to the holder of the debt.

Income
Accrual Date

Determines when the security begins to accrue income. In the first year
of issue a bond might have an irregular payment cycle known as a
long or short first coupon.

Coupon or
Interest Rate

The rate which determines the total annual payment of interest on the
principal amount borrowed. This rate can be fixed or floating.

Payment
Frequency

Interest bearing securities can pay coupons at various frequencies.

Typically they pay annually or semi-annually.

Accrual
Convention

Different bonds have different methods for calculating how interest is

accrued on them. These methods are known as accrual conventions.
The conventions are outlined below:

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ABCD

30/360

Assumes twelve months of thirty days each e.g. A 30/360

bond will accrue 30 days interest in February (28 actual
days) and 30 days interest in March (31 actual days).

A/360

This accrual convention is common for short term securities

(i.e. with maturity of less than 1 year). Assumes a
denominator of 360 days to calculate the annual income and
uses the actual number of days in the period as numerator.

A/365

UK and Irish Gilts (Treasury Bonds as described in Ireland

and England) use this methodology.

A/A

This convention applies to US T-Bonds. It assumes that the

year is divided unevenly into two parts either 181 + 184
days or 182 + 183 days. The amount of the daily accrual
changes from one period to the next but the total coupon
received is equal in both periods.

Given all the information listed above, it is possible to calculate the interest accrual on any
bond at any point in time.
The following three examples list all accrual types:
Example 1 (30/360)
Bond description:

German Govt Bond 10% 22/07/2010

Currency:
Coupon:

Eur
10%

Coupon Frequency:

Annual

Accrual Convention:

30/360

Maturity Date:

22/07/2010

Interest Accrual Date:

22/07/2000

Our fund has a holding of 87,713,000 face as at 30/09/2005.

We need to calculate the accrued income entitlement the fund has for the 30/09/2005
valuation.
The formula to calculate the income is:
Face x Coupon x Number of 30/360 Days in Accrual = Accrued Income
360

63

ABCD

The accrual period is equal to the total number of days between the last coupon date and the
date of the accrual. In order to determine the number of 30/360 days there are in the accrual
period we need to undertake the following calculation.
Last coupon date 22/07/2005 to Current Accrual Date 30/09/2005
22/07/05 30/07/05

9 days inclusive

30/07/05 30/08/05

30 days

30/08/05 30/09/05

30 days

Total 30/360 days

69 days

Applying the formula to our example:

87,713,000 x 10%
(the annual coupon
payment)

x 69/360
(the amount of the
annual coupon accrued
to date)

= 1,681,165.83
(accrued income to
30/09/05)

Example 2 (Act 365)

Bond description:

Irish Gilt 9.5% 01/06/2018

Currency:

Eur

Coupon:

9.5%

Coupon Frequency:

Semi-Annual

Accrual Convention:

Act/365

Maturity Date:

01/06/2018

Interest Accrual Date:

14/08/2001 (implies a short first coupon in 2002)

Our fund holds 4,750,000 face as at 04/10/2005

Again, we want to calculate the accrued income entitlement for 04/10/2005.
The formula in this case is:
Face x Coupon x Number of actual days in the Accrual = Accrued Income
365
In this example, the accrual period is equal to the total number of actual days between the
last coupon date and the income accrual date.
Last coupon date 01/06/2005 to Current Accrual Date 04/10/2005
01/06/05 30/06/05 =

30 days inclusive
64

ABCD

30/06/05 31/07/05 =

31 days

31/07/05 31/08/05 =

31 days

31/08/05 30/09/05 =

30 days

30/09/05 04/10/05 =

4 days

Total actual days =

126 days

Applying the formula to our example:

4,750,000 x 9.5%
(the annual coupon
payment)

x 126/365
(the amount of the
annual coupon accrued
to date)

= 155,773.97
(accrued income to
04/10/05)

Example 3 (Act/Act)
Bond description:

US Treasury Bond 7.0% 15/05/2015

Currency:

USD

Coupon:

7%

Coupon Frequency:

Semi-Annual

Accrual Convention:

Act/Act

Maturity Date:

15/05/2015

Interest Accrual Date:

15/05/2000

Our fund has a settled holding of 56,700,000 face.

We wish to calculate what the income entitlement would be as at the 21/10/2005.
The formula in this case is:
Face x Coupon x

Number of actual days in Accrual / 2 = Accrual to Date

Number of Actual Days in Current Period

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ABCD

The effect of this formula is illustrated in the diagram.

Act/Act Accrual for US Treasury 7% 15/05/2015
56,700,000 x 7% = 3,969,000
Annual Coupon

15/05/05

1,984,500

1,984,500

15/11/05

15/05/06
181
1,984,500 / 181
Daily Accrual in
Period Two

184
1,984,500 / 184
Daily Accrual in
Period One

The daily accrual in the first period will be marginally different from the accrual in the
second 10,875.33 vs 10,964.09.
Applying the formula to the example we get the following result:
56,700,000
(the

annual

payment)

7%
coupon

x
(the

160/184

amount

of

the

annual coupon accrued

1,725,652.17

(accrued

income

to

21/10/05)

to date)
All of the above examples illustrate the different accrual conventions. It is important to note
that the misapplication of an accrual convention to all or any of the above examples could
result in a material change to the funds NAV.
For example, the US treasury bond if accrued on a 30/360 basis would have resulted in an
accrual of 1,719,900 vs 1,725,652.17, a difference of 5,752.17.

7.5

Smoothing
In the case of funds that produce a valuation on a daily basis, an adjustment must be made
for bonds that accrue on a 30/360 basis. This is to allocate the income on a 30/360 basis over
the actual number of days in the coupon accrual period. For example, without smoothing the
income accrued for a 30/360 bond on March 31 would be zero or on March 1 would be three
days (February 28 plus two remaining days in a 30/360 day month).

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ABCD

This situation is avoided by a calculation which allocates the total 30/360 coupon over the
actual number of days in the coupon period. There is a smooth flow of income for each
days valuation which ensures a level yield for daily priced valuations.
Example
A corporate bond pays interest semi-annually as follows:
Interest payment dates:

30 June, 31 December

Interest day count:

30/360

Interest rate:

10%

Fund ABC holds US$1,000,000 nominal of this bond throughout 2005. The daily interest
accruals throughout 2005 are calculated as follows:

1)

2)

01/01/05 30/06/05
Total interest accrual 01/01/056 30/06/05
(i.e. half the annual interest amount)

US$50,000

Total number of days 01/01/05 30/06/05

182 days

Daily interest accrual

US$274.73

01/07/05 31/12/05
Total interest accrual 01/07/05 31/12/05
(i.e. half the annual interest amount)

US$50,000

Total number of days 01/01/05 30/06/05

184 days

Daily interest accrual

US$271.74

Note that if there is a sale or purchase on the bond during the period that there will be a
mismatch between what has been posted to the income account and what will be realised in
cash. As a result an adjusting entry would have to be made.

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ABCD

7.6

Earned Income
The final income related concept that will be dealt with in this chapter relates to the
calculation of Earned Income. As the valuation of the portfolio is periodic the change in
income must be measured over a period of time. The following calculation measures that
movement.

Accrued Income at the end of the period

- Accrued Income at the beginning of the period
+ Income Sold
- Income Purchased
- Income Collected
Earned Income for the period

It is important to note that purchases and sales of income accruing securities must be
accounted for in the accrual movement in any valuation period.

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ABCD

Chapter 8 - Fund Expenses

The allowable expenses which can be charged to the fund must be disclosed to the investor
in the funds prospectus. As the fund is a business entity only expenses relevant to it can be
charged against it.
Typically, the following expenses are charged to a fund:
Investment Advisory Fee/Investment Management Fee
Usually the largest expense charged to the fund. The Investment Advisory fee is charged
in basis points of Total Net Asset value. Sometimes there is also a provision for a
performance fee in the fee agreement between the fund and the investment advisor. The
payment of the performance fee is contingent on satisfying specific measurable
investment criteria.
Shareholder Services
Includes fees and expenses for the transfer agent and dividend disbursing agent. These
are often times a combination of fixed and floating expenses.
Distribution Expenses
Custodian Fees
The custody fee can be further subdivided to a transactional charge combined with a basis
point charge. Most custodians will retrieve the operational costs of the settlement and
registration of securities. There may be a premium on charges for the safekeeping of
assets in less developed markets.
Administration Fee
Usually a basis point of NAV charge with a minimum level.
Trustee Fee
Usually a basis point charge.
Usually the fees are disclosed individually on the Income Statement and Statement of Net
Assets. Fees must be accrued for each valuation produced under the accruals concept.

8.1

Introduction to Fund Expenses

A fund will incur various expenses as a result of its daily operations. These expenses are
mostly comprised of fees to the various service providers (as described above) to the fund
including the investment advisor.

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ABCD

The three main categories of expenses are:

Contractual expenses
Fixed expenses
Performance fees/equalisation

8.2

Contractual Expenses
Contractual expenses are fees paid to the funds service providers based on a percentage of
the funds net or gross assets. Each funds service level agreement (SLA) with a service
provider is unique, and this agreement will include the method of calculating the fees and
well as the levels of services and responsibilities expected from both parties.
Contractual expenses are usually based on an annual percentage (expense ratio) of the funds
net assets, which is accrued daily and normally paid on a monthly or quarterly basis. The
exact amount of the expense cannot be determined as net assets will most likely change on a
daily basis. This is overcome by applying the annual percentage to prior day net assets and
dividing by the number of days in the year.
In may cases, the expense ratio will change as the funds net assets exceed specified levels.
These levels are referred to as breakpoints.
Basis points are often used in place of percentages as expense ratios are often only a fracture
of one percent.

0.01 = 1% = 100 Basis Points

Common examples of contractual fees are:
Accounting agent fees
Investment advisory (management) fees
Administration fees
Custody fees
Shareholder services fees
Trustee and Custodial fees

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ABCD

Example of a contractual fee schedule:

The investment advisory fee schedule is given as follows:
.46% of the first 10 million of net assets.
.41% of net assets over 10 million but less than 20 million.
.12% of net assets over 20 million but less than 30 million.
.08% of net assets exceeding 30 million.
The breakpoints for this schedule are 10 million, 20 million and 30 million Euros.
Calculation of the daily advisory fee is as follows:
Fund Net Assets: 58,695,430 (Prior day)
10,000,000 @ 46BPS (0.0046)/365 = 126.03
10,000,000 @ 41BPS (0.0041)/365 = 112.33
10,000,000 @ 12BPS (0.0012)/365 =

32.88

28,695,430 @ 08BPS (0.0008)/365 =

62.89

Daily Advisory fee

= 334.13

Accounting entries:

8.3

Dr.

Advisory Fee YTD

[P&L]

334.13

Cr.

Accrued advisory fee

[B/S]

334.13

Fixed Expenses
Fixed expenses (non-contractual) are based on a budget of estimates of certain fund expenses
incurred in a year. These budgeted expenses are based on the previous years expenses,
estimates from vendors and anticipated fund growth.
Examples of some fixed expenses (non-contractual) are:
Insurance
Legal fees
Audit fees
Registration fees
Shareholder reports printing, postage etc
Miscellaneous items
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ABCD

The expense budget is reviewed and, if necessary, adjusted severe times a year (usually
quarterly).
Example:
Audit fees or the XYZ fund for last year were 5,000. This year as the fund has grown
substantially and from experience it is decided to budget 6,000.
Starting on January 1st the fund will accrue on a daily basis:

Dr.

Audit expense YTD

[P&L]

16.44

Cr.

Accrued audit fee

[B/S]

16.44

(6,000 / 365 = 16.44 rounded)

On March 1st the fund will have accrued 1,479.60. The fund has experienced huge growth
during this quarter and it now appears from an estimate from our auditors that the annual fee
will be almost 7,000.
The daily accrual will have to be adjusted to consider this revision.

Original budget

6,000.00

Daily accrual
Jan 1st to April 1st

16.44

Total accrued

1,479.60

New budget

7,000.00

Remainder to be accrued

5,520.40

Days remaining
April 1st to Dec 31st

275

New Daily accrual

20.07

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ABCD

On 1st April the daily accrual will be:

Dr.

Audit expense YTD

[P&L]

20.07

Cr.

Accrued audit fee

[B/S]

20.07

Expense Payments
The accounting entry for the payment of a bill:
Dr.

Accrued Expense (use specific a/c)

[B/S]

xx

Cr.

Cash

[B/S]

xx

An expense analyses (or schedule) of all accruals and any payments of expenses must be
maintained by the fund accountant.

8.4

Organisational Expenses
When a fund is being set-up there are some expenses which are sometimes regarded for NAV
calculation purposes as assets to the fund. These expenses include Legal Fees, Printing and
Publishing, Marketing Expenses, or any expense regarded as necessary to ensure the
successful establishment of a fund.
These expenses are set up as assets on the accounts and amortised over a period not greater
than sixty months from the date operations began. The amortisation is on a straight line
basis. This treatment of amortising (capitalising) the organisational expanses and writing
them off gradually is contrary to IFRS, UK and IRE GAAP (and most other accounting
standards), as the correct accounting treatment is to expense the costs fully as they occur.
The straight line basis ensure that the initial shareholders do not bear the weight of the
organisational expenses alone and that future subscribers (who will benefit from the
expertise required to establish the fund) also bear a portion of the cost associated with it.

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ABCD

8.5

Performance Fees and Equalisation

The existence of performance-based fees is a relatively new phenomenon in terms of
Investment Funds. The reason being that a fee calculation based purely on the fund gaining a
profit for its investors has proved difficult to calculate. It is also something investment
managers have not been enthusiastic to enforce due to the cyclical nature of markets and thus
the underlying value of the assets under management.
Hedge Funds and Performance Fees
The term Hedge Fund is a generic term, to hedge is the process of protecting your
investments against unfavorable changes in the market. Thus, a Hedge Fund seeks to hedge
against risk in one way or the other thus deliver profits in all circumstances (in bull and bear
markets).
It is such Funds and the evolvement of the securities necessary to achieve such an approach
(derivatives), which has allowed the introduction of performance fees. Investment Managers
can now charge a high fee purely on performance.
Equalisation
Equalisation is a process of taking each individual investor and accounting for their profit
gained from the fund on a shareholder-by-shareholder basis. This way each shareholder pays
the correct amount of fee on the performance earned.
For example:
Shareholder A buys in at a NAV of 110, the closing NAV at the end of the year is 120, thus
the performance earned by this investor is 10, if performance fees are payable at 20% then
this investor will pay away a 2 performance fee on their holding.
Terminology
High Water Mark: The initial NAV of the Fund at the beginning of a financial year or at
the opening of the Fund.
Gross Asset Value (GAV): The Net Assets of the Fund divided by the number of shares
held before any performance fees are included.
Net Asset Value (NAV): The Net Assets of the Fund minus any performance fees, then
divided by the number of shares.
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ABCD

Equalisation Credit: A credit given to the investor who comes in above the high water
mark, which is redeemed in shares at the end of the year.
Contingent Redemption: A redemption factor calculated against an investor who comes
in below the high water mark, to avoid an investor gaining a free ride.

8.6

Expense Caps, Waivers and Reimbursements

Some funds operate under an expense cap. An expense cap is a ceiling on the operating
expenses of a fund. The funds investment advisor guarantees the funds operating expenses
will not exceed a certain ratio of the funds net assets. The advisor maintains the cap through
the use of expense waivers and reimbursements.
The advisor will be prepared to waive a portion of their fees to keep the funds total expense
ratio at a certain pint. If the different between the funds actual operating expenses and the
funds expense cap is greater than the advisors fee then the advisor may reimburse the fund
for the different. This is common when a fund starts as the advisor is waiving all of their
fees and the fund has a cap.
The advisor may also arrange for some of the other parties to the fund to waive some of their
fees during the initial start-up period. All expenses, waivers and reimbursements should be
accounted for separately and not netted against each other.
The fund prospectus will contain details of any expense caps, waivers and other party
agreements.
Ensuring correct expense accrual calculation is very important as expenses reduce net
income.

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ABCD

Chapter 9 - Accounting for Investments

9.1

Equities
In exchange for introducing capital to a company equity investors obtain the right to have
some influence over its management. The larger the stake, the greater the influence. Most
investing funds restrict their investment in any one company to below 10% of its issued
capital so that they do not take a management role in the companys operations.
There are two distinct routes for purchasing equities:
(i)

Direct Injection
a. Private placing of shares
b. Rights issue
c. Management buyout (MBO) support
d. Venture capital promotion of a start-up situation

(ii)

Via the Secondary Market (e.g. the Stock Exchange)

a. Buying from an existing shareholder
b. Placing of existing shares
c. Buying rights from an existing shareholder

Mostly investors will purchase shares in the market using the services of a stockbroker. In
general, the purchase of shares is executed on one day, referred to as trade date and the
investor must pay for the shares (i.e. settle his/her account with the broker) some day later,
settlement date. For example, if a fund buys a Korean equity, settlement may be two days
later. The accounting entries for recording purchases and sales of equity securities are set out
below.
The book entries for the purchase of shares are:
Dr
Cr

Equity investment book cost (B/S)

Outstanding settlements (B/S)

XX
XX

On advice of settlement the credit is removed with the following entries:

Dr
Cr

Outstanding settlements (B/S)

Bank (B/S)

XX
XX

Effectively the transaction is now closed on the accounting side.

76

ABCD

Example Equity Purchase

Bought:

6,000 Dell plc @ $9.00

Trade Date:

3 February 2010

Settlement Date:

7 February 2010

Dealing Costs:

1% of consideration

Items on contract note will include:

$
Consideration

54,000 (6,000 x $9)

Dealing costs

540 (54,000 x 1%)

Contract total for settlement

54,540

Accounting Entries
On trade date, 3 Feb 2010:
Dr
Cr

Equity investment book cost (B/S)

Outstanding settlements (B/S)

$54,540
$54,540

On settlement date, 7 Feb 2010:

Dr
Cr

Outstanding settlements (B/S)

Bank (B/S)

$54,540
$54,540

On the sale of a security the accounting cost of the holding sold is credit to the book cost
account and the difference between that and the sale proceeds is the profit (loss) on disposal.
The book entries for the sale of shares are:
Dr
Cr
Cr

Outstanding settlements (B/S)

Equity investment book cost (B/S)
Profit on disposals
or

Dr Loss on disposals

On settlement:
Dr
Cr

Bank (B/S)
Outstanding settlements (B/S)

Example Equity Sale

Sold:

3,000 Dell plc @ $10.00

Trade Date:

15 April 2010

Settlement Date:

19 April 2010

Dealing Costs:

1.5% of consideration

77

ABCD

Items on contract note will include:

$
Consideration

30,000.00 (3,000 x $10.00)

Dealing costs

(450.00) ($30,000 x 1.5%)

Contract total for settlement

29,550

Accounting Entries
On trade date, 15 April 2010:
Dr

Outstanding Settlements (B/S)

$29,550

Cr

Equity Investment Bookcost (B/S)

Cr

Realised gain on Sale of Securities (P&L)

$27,270
$2,280

On advice of settlement, 19 April 2010:

Dr

Bank (B/S)

Cr

Outstanding settlements (B/S)

$29,550
$29,550

There is an added complication when the fund purchases foreign currency securities, due to
the introduction of exchange rates. The foreign currency trade is recorded in the books of
account on trade date at the exchange rate prevailing on that date. When settlement is made
some days later, the exchange rate will have moved and this will lead to an exchange gain or
loss arising, as the settlement will be recorded at the exchange rate prevailing on settlement
date.

Accounting Entries for the Purchase of a Foreign Security:

Dr

Equity investment bookcost (B/S)

(exchange rate on trade date)

Cr

Outstanding settlements

(exchange

rate

on

trade

date)

(amounts due to brokers)

On settlement:
Dr

Outstanding settlements

(exchange rate on trade date)

Cr

Bank

(exchange rate on settlement date)

Cr

Foreign exchange Gain

or

Dr Foreign Exchange Loss

78

ABCD

Example Foreign Equity Purchase

Bought:

10,000 Sony Corp @ Yen100

Trade Date:

16 May 2010

(exchange rate 1 = Y100)

Settlement Date:

19 May 2010

(exchange rate 1 = Y105)

Dealing Costs:

1% of consideration

Base Currency of Funds:

Eur

Items on a contract note will include:

Yen
Consideration

1,000,000 (10,000 x Yen100)

Dealing costs
Contract total for settlement

10,000 (Yen1,000,000 x 1%)

1,010,000

Accounting Entries
On trade date, 16 May 2010:
Dr

Equity Investment Bookcost (B/S)

Cr

Outstanding settlements (B/S)

10,100 (1,010,000 / 100)

10,100

On settlement date 19 May 2010:

Dr

Outstanding settlements (B/S)

10,100

Cr

Bank (B/S)

9,619.05 (Y1,010,000 / 105)

Cr

Foreign exchange gain (P&L)

480.95

In this example because of the exchange rate movement, the fund had to pay less sterling and
therefore a foreign exchange gain has arisen on the settlement of the transaction.

9.2

Fixed Interest Securities

Stocks which provide a fixed level of income are priced and traded similarly to equities
except that there is always an element of accrued interest in the price. The quoted price of a
fixed interest security can be clean or dirty. Clean means that the accrued interest is not
included in the price quoted for the bond, dirty means that it is. When an investor is buying
a fixed interest security which is quoted clean, he/she must add to the consideration an
amount in respect of the interest accrued to the settlement date of the trade. Note that the
price of an Eur fixed interest security is quoted as Eur per Eur100 nominal.

79

ABCD

For accounting purposes the interest element is treatment separately to the capital element
because unlike equities, the accrued amount of income can be easily identified by applying
he fixed rate associated with the stock. Such interest bought and interest sold is calculated
from the last interest payment date to settlement date.
Example Fixed Interest Purchase
Bought:

200,000 8% Treasury Stock 2020 @ 105* (clean price)

Trade Date:

4 March 2010

For Settlement:

5 March 2010

Dealing Costs:

Nil

Last interest payment date:

22 January 2010

* Remember that bond price are expressed in %

Items on the contract note will include:

Consideration

210,000 (200,000 x 105%)

Accrued Interest

1,841 (200,000 x 8% x 42/365 days)

Contract total for settlement

211,841

Accounting Entries
On trade date, 4 May 2010:
Dr

Fixed Interest investment bookcost (B/S)

Dr

Interest purchased (B/S)

Cr

Outstanding settlements (B/S)

210,000
1,841
211,841

On advice of settlement, 5 May 2010:

Dr

Outstanding settlements (B/S)

Cr

Bank (B/S)

211,841
211,841

Example Fixed Interest Sale (taking the example above forward)

Sold:

50,000 8% Treasury Stock 2020 @ 108 (clean price)

Trade Date:

25 March 2010

For Settlement:

26 March 2010

Dealing Costs:

Nil

Last interest payment date:

22 January 2010

80

ABCD

Items to be seen on the contract note will include:

Consideration

54,000 (50,000 x 108%)

Accrued Interest

690 (50,000 x 8% x 63/365 days)

Contract total for settlement

54,690

Accounting Entries
On trade date, 25 March 2010:
Dr

Outstanding settlements (B/S)

54,690

Cr

Interest sold (B/S)

Cr

Fixed interest investment book cost (B/S)

Cr

Realised gain on disposal (P&L)

690
52,500 (50,000 x 105%)
1,500*

* Book cost (50,000 x 105% = 52,500) Proceed (50,000 x 108% = 54,000) = Realised gain of 1,500

On advice of settlement 26 March 2010:

Dr

Bank (B/S)

54,690

Cr

Outstanding settlements (B/S)

54,690

NB: The remaining 150,000 holding has interest of 2,071 accrued as at 26 March, with a
book cost of 157,500

9.3

Money Market Instruments

The accounting treatment of money market instruments such as Certificates of Deposits and
Commercial Paper is the same as that for fixed interest securities, in that there may be an
element of accrued interest bought or sold in the consideration period.
When a fund places a fixed deposit with a credit institution there will be no element of
accrued interest.
Example Fixed Deposit
Place:

1,000,000

Value/Settlement Date:

10 April 2010

Maturity Date:

17 April 2010

Rate of interest:

5%

81

ABCD

Accounting Entries
On value date, 10 April 2010:
Dr
Cr

Fixed deposit (B/S)

Cash (B/S)

1,000,000
1,000,000

On maturity date, 17 April 2010:

Dr Cash (B/S)
Cr Fixed Deposits (B/S)
Cr Fixed Interest Received (P&L)

1,000,958.90
1,000,000.00
958.90

Quick Question
In May 2010 the following transactions were carried out by ABC Fund Plc:
a)

1 May purchase 1,000 Misys shares at 2.30, settlement 6 May

b)

5 May purchase 10,000 8% Treasury Stock 2009 at 1.01, settlement date 5

May. Interest accrued to 5 May 67.95.

c)

19 May sold 400 Misys shares at 2.50, settlement date 25 May

Show the appropriate accounting entries for each date.

Answer
1 May

Dr
Cr

Equity Investment Bookcost (B/S)

Outstanding Settlements (B/S)

5 May

Dr
Dr
Cr

Fixed Interest Investment (B/S)

Interest Purchased (B/S)
Cash (B/S)

10,100.00
67.95
10,167.95

6 May

Dr
Cr

Outstanding Settlements (B/S)

Cash (B/S)

2,300.00
2,300.00

19 May

Dr
Cr
Cr

Outstanding Settlements (B/S)

Equity Investment (B/S)
Realised gain on Sale of Securities (P&L)

1,000.00
920.00
80.00

25 May

Dr
Cr

Cash (B/S)
Outstanding Settlements (B/S)

1,000.00
1,000.00

82

2,300.00
2,300.00

ABCD

9.4

Corporate Actions
A.

Rights issues

Rights are issued by companies who wish to raise funds for investment without having to
resort to borrowings. A rights issue gives existing shareholders the right to subscribe for
additional shares in the company in direct proportion to their current shareholding.
When a shareholder is offered new shares for cash by way of a rights issue he can take one of
the following investment alternatives:
a)

Exercise the rights and purchase the new shares.

(In this case the investment in the company is increased, but there is no increase in
the investors share of the company)

b)

Sell all the rights on the market.

(Here the investor will reduce his share of the investment in the company)

c)

Sell sufficient rights to take up the balance.

(This is the best course for an investor to adopt where he does not want to put up
further money, yet wishes to retain his maximum possible interest in the company)

d)

Let the rights lapse.

(This is the worst course of action as the shareholder will lose money as the market
price of the shares is above the rights price)

Accounting Entries for Rights Issue

On Ex date, i.e. the date the shareholder becomes entitled to the rights, a new line of stock is
added to the portfolio for the nil paid rights.
a)

b)

Rights are held until call payment is due and paid:

Dr

Equity book cost (B/S)

Cr

Bank (B/S)

XX
XX

Rights are sold in the market:

Dr

Outstanding settlements (B/S)

Cr

Profit on equities (P&L)

XX
XX

On settlement:
Dr

Bank (B/S)

XX

Cr

Outstanding Settlement (B/S)

83

XX

ABCD

c)

Sell sufficient rights to take up the balance. The accounting entries will be a
combination of (a) and (b) above.

d)

Let the rights lapse, no accounting entries required

On payment of the call amount, shares obtained via a rights issue become a normal equity
investment and are treated accordingly, providing they rank pari passu in all respects with the
main holding. Shares received as a result of a rights issue will be amalgamated with the
main holding in due course.
Rights Issue Example
A company announces a rights issue of one 50p ordinary share at 1.50 for every five 50p
ordinary shares held (i.e. 1 for 5) on 2 April 2010. The call payment is due and payable on 7
April 2010.
The middle market price of the shares before the start of dealings was 1.75.
The estimated premium on the new shares (nil paid) before dealings start is calculated as
follows:
Initial Holding

500 shares @

Worth

875.00

Receives

1.75
100 shares @

Cost

150.00

1.50
600 shares

Worth

Subsequent
holding

Therefore, each share should now be priced @

1.71 (1,025 600)

Estimated premium on new shares (nil paid)

1.71 - 1.50 = 21p

Accounting Entries
On call date, 7 April 2010:
Dr
Cr

Equity Investment Book cost

Bank

B.

Bonus Issues

150 (100 x 1.50)

150

84

1,025.00

ABCD

A bonus issue is used by a company to increase the shares in issue without any
exchange of cash. The number of shares a shareholder receives is in proportion to
their current holding.
As no money changes hands, there are no accounting entries except to the increased
holding of shares.

C.

Dividend Stock Options

Certain companies give shareholders the choice to receive extra shares in the company
instead of a cash dividend. Such a dividend is referred to as a stock or scrip dividend.
The shareholder can choose one of the following options:

a)

Receive the cash dividend

b)

Receive the new shares

If the shareholder chooses to receive the cash dividend then the accounting entries are
simply:
Dr
Cr

Bank (B/S)
Dividend Income (P&L)

1,000,958.90
1,000,000.00

If the shareholder chooses to receive the new shares, the bookcost of these shares is
considered to be the value of the cash dividend foregone.
Accounting Entries
Dr
Cr

Equity Investment Bookcost (B/S)

Equity dividend (P&L)

XX
XX

There is no debit or credit to the bank account as there is no physical receipt or payment of
cash.
Example Dividend Stock Option
Stock dividend declared:

0.25 per share

Current share price:

10.00 per share

Number of shares held:

2,000

The shareholder will receive 50 new shares (2,000 shares by 25c divided by 10). The
holding will be increased by 50 shares, the following book entries are required:
85

ABCD

Dr
Cr

Equity Investment Bookcost (B/S)

Equity dividend (P&L)

D.

Stock Splits

500
500

A stock split is used by a company to increase the number of shares in issue without
exchange of cash. The split reduces the market value and par value of each new share.
As there is no effect on the bookcost of the investment, there are no accounting entries
required. However, the number of shares the fund holds will need to be amended to
reflect the stock split e.g. if the fund holds 1,000 shares and there is a 2:1 stock split
the new holding the fund has in the stock is 2,000 shares.

9.5

Property
Basic accounting for properties is very similar to accounting for all other forms of
investment. The accounting entries are as follows:
a)

b)

Purchase of a property:
Dr

Property bookcost

Cr

Bank

Sale of a property:
Dr

Bank

Cr

Property bookcost

Cr

Profit in disposal

or

Dr

Loss on Disposal

The accounting treatment of property depends on the reason for the acquisition of the
property. A property which is held as an investment by a mutual fund, should be valued at
open market value on the balance sheet of the fund and the realized and unrealized gains
/losses are reflected in the profit and loss account. Property which is acquired as a fixed asset
by a business (i.e. which has a long life and is to be used in the business, not an investment)
is accounted for on a historic cost basis and is generally subject to depreciation charges to
reflect the gradual decrease in the value of the property over time.

86

ABCD

9.6

Accounting for Derivatives

The most important concept in determining how to account for derivatives is the accruals
concept, which permits the matching of costs and income. This section deals with the
accounting for futures and options, which are probably the most widely used derivatives.
A.

Futures

See also chapter 25.2 Futures

A futures contract is a legally binding agreement to buy or sell a specified asset at a fixed
time in the future. When a futures contract is traded, the buyer and seller agree, at the time
of the trade, the price for the underlying asset which will be delivered (and finally paid for)
in the future.
What is an Initial Margin?
Anyone buying or selling a financial futures contract is required to lodge a deposit called and
initial margin. This is a fixed amount per contract and must be left in place as long as a
position is held. Its purpose is to secure the performance of the buyers obligations under the
contract. In addition, a variation margin is received, or paid on a daily basis, as the position
held generates profits or losses with movements in market rates.
The two primary uses of financial futures are hedging and trading.
Hedging aims to reduce the risk of loss through adverse movements in financial rates by
taking a position in a financial futures contract that offsets the existing or anticipated position
in the cash market.
Trading in financial futures contracts enables organisations or individuals to seek profits
from rises or falls in interest rates without necessarily having to buy or sell the underlying
financial instrument, e.g. a gilt or the FT-SE 100 Index. There may be no intention to hold
them but to rely on price changes in order to sell at a profit before delivery.
Each day open financial futures are market to market (i.e. valued at market value) and the
profit or loss for the day paid over by way of variation margin.
Every financial futures contract has a contract size. For example, the FT-SE 100 future has a
contract size of 25. The current value of one FT-SE 100 future is calculated by multiplying
the current FT-SE 100 Index by 25.

87

ABCD

Example Futures Contract

On Day 1 a fund buys (to open) 5 August FT-SE 100 @ 2835
Contract Size:

25 per contract

Initial Margin:

2,500 per contract

FT-SE 100 Index on Day 1:

2835

FT-SE 100 Index on Day 2:

2839

FT-SE 100 Index on Day 3:

2825

On day 4 the fund sells (to close) 5 August FT-SE 100 futures @ 2840
Day 1
Initial Margin
The fund is required to lodge a deposit, referred to as initial margin, with the broker on Day
1. The initial margin is a fixed amount per contract and for the FT-SE 100 futures this
amount is 2,500 per contract. This margin will be returned to the fund when the position is
closed.
Initial Margin Payable:

12,500 (2,500 x 5 contracts)

Accounting Entries
Dr

Initial Margin on Futures (B/S)

Cr

Bank (B/S)

12,500
12,500

Day 2
Variation Margin
The futures are valued at market value each day. As a result, profits or losses are generated
and the fund receives profits and pays losses by way of a variation margin on a daily basis.
The price of the FT-SE 100 Index on Day 2 is 2839. The variation margin is calculated as
follows:
Opening Contract Price

2835

Index Price on Day 2

2839

Gain

Variation Margin = 500 (4 x 25 (contract size) x 5 contracts)

Accounting Entries
Dr

Variation margin on Futures (B/S)

Cr

Unrealised gain on Futures (P&L)

88

500
500

ABCD

Day 3
The variation margin on Day 3 is calculated based on the movement in the price of the index
between days 2 and 3.
Index Price on Day 2

2839

Index Price on Day 3

2825

Loss

14

Variation Margin = 1,750 (14 x 25 x 5 contracts)

Accounting Entries
Dr

Unrealised loss on Futures (P&L)

Cr

Variation Margin on Futures (B/S)

1,750
1,750

Day 4
The fund sells 5 FT-SE 100 futures @2840 to close the position. At this stage, the initial
margin of 12,500 will be returned to the fund. On Day 4 the funds bank account will be
credited with the following:
Return of initial margin

12,500

Valuation margin for Day 4

1,875 Gain (15 x 25 x 5)

14,375

The overall profit on the futures is calculated as follows:

Buy/Opening Cost

354,375 (2,835 x 25 x 5 contracts)

Valuation margin for Day 4

355,000 (2,840 x 25 x 5 contracts)

Gain on futures

625

The gain on futures is equal to the total variation margins of on Days 2, 3 and 4 (500 1,750 + 1,875). The variation margin for Days 2 and 3 should now be re-classified as
Gain on Futures.
Accounting Entries to close the futures positions are:

89

ABCD

Dr

Bank (B/S)

14,375

Cr

Initial Margin on Futures (B/S)

12,500

Cr

Unrealised g/l on futures (Reversal) (P&L)

Cr

Realised gains on Futures

B.

1,250
625

Options

See also chapter 25.3 Options

An options contract gives the holder the right to either buy from or to sell to the
counterparty a given number of securities at a given price within a specified period.
A call option confers the right, but not the obligation to buy an underlying security at a
specified price within or at the end of predetermined period of time.
A put option confers the right, but not the obligation to sell an underlying security at a
specified price within or at the end of a predetermined period of time.
The purchaser of an option must pay a fee, referred to as the premium for this right or option.
The premium is paid to the party which has accepted the obligation under the terms of the
option, the option writer.
Activating the option is called exercising the option. The fixed price agreed now which the
option buyer pays when activating or exercising the option is the exercise price. If, as a
result of the market movements, during the exercise period the terms of the option become
unfavorable, the purchaser of the option may decide to let it lapse.
Options can be traded in the same way as equities, bond, etc and they can have a current
market price.
Example Options
(this example is a call option but the same principles apply for all options)
A fund purchases Glaxo traded options as follows:
50 Contracts

@ 30p premium

Contract size:

1000

Trade Date:

4 June 2010

Settlement Date:

5 June 2010

90

ABCD

Option terms: to acquire 50,000 Glaxo ordinary shares at an

exercise price of 6
Exercise period:

25 June 2010 30 June 2010

The total premium payable on 4 June is 15,000 (50 contracts x 1,000 x 30p)
Accounting Entries for treatment of options
a) On advice of purchase of 50 contracts @ 30p, 4 June 2010:
Dr

Option investment (B/S)

Cr

Outstanding settlements (B/S)

15,000
15,000

On settlement date, 5 June 2010:

Dr

Outstanding settlements (B/S)

Cr

Bank (B/S)

15,000
15,000

b) The option moves in the market from 30p to 35p. The current value (50 x (35
30)) of the option is 17,500 resulting in an unrealised gain of 2,500
Dr

Option investment

2,500

Cr

Unrealised gain on options

2,500

c) The option is exercised on 25 June 2010 when the price of Glaxo shares are 6.50.
There are a number of steps involved in accounting for the exercise of the option.
Firstly an unrealised gain/loss on the option up to exercise date must be reversed.
The option premium paid must be transferred from the option investment account
to the equity investment account. The purchase of the 50,000 Glaxo ordinary
shares must be recorded, and finally the new unrealized gain/loss on the new Glaxo
shares need to be recorded.
To reverse the unrealised gain of 2,500:
Dr

Unrealised Gain on Options (P&L)

Cr

Option Investment (B/S)

2,500
2,500

To move the premium paid for the option to the cost of the new shares:
Dr

Equity Investment (B/S)

Cr

Option investment (B/S)

91

15,000
15,000

ABCD

To record the purchase of 50,000 shares at 6 per share:

Dr

Equity Investment (B/S)

Cr

Bank (B/S)

300,000
300,000

To record the unrealised g/l on the 50,000 shares, current market value is 6.50:
Cost is 315,000 (300,000 + 15,000), market value is 325,000 (50,000 x 6.50),
therefore unreal gain is 10,000.
Dr

Equity Investments (B/S)

Cr

Unrealised gain (P&L)

10,000
10,000

d) The fund then sells the Glaxo shares for 6.50 on 26 June 2010 for settlement 28
June 2010.
The realized gain is calculated as follows:
Sales Proceeds

325,000

Bookcost of Shares

(50,000 shares x 6.50)

(300,000)

Option Premium

(15,000)

Gain on Sale

10,000

On trade date 26 June 2010:

Dr

Outstanding settlements (B/S)

Cr

Equity Investment (B/S)

Cr

Realised gain on Investments (P&L)

325,000
315,000
10,000

On settlement date, 28 June 2010:

Dr

Bank (B/S)

325,000

Cr

Outstanding settlements (B/S)

325,000

e) Instead of (c) and (d) above the fund might have sold the option if its price was
perhaps 40p and the market price of the Glaxo shares was unfavorable:
Dr

Bank (B/S) - (50 x 40p)

20,000

Cr

Option investment (B/S) (50 x 30p)

Cr

Realised Gain on Options (P&L)

92

15,000
5,000

ABCD

f) If the market price of the Glaxo shares during the exercise period was 5.50 the
option would be allowed to lapse.

9.7

Dr

Realised loss on Options (P&L)

Cr

Option Investment (B/S)

15,000
15,000

The Importance of an Accurate Net Asset Value

The primary responsibility of each fund accountant is the calculation and timely distribution
of an accurate NAV per share. The NAV (e.g. Eur19.23 / share) is the net asset value per
share of a fund; this is the Euro amount per share a prospective shareholder would pay to
invest in a fund or the amount current shareholder would receive for shares redeemed out of
a fund.
The prospective and current shareholders of a mutual fund use the funds NAV to make
investment decisions. A funds NAV can impact the financial planning of a shareholder.
If an incorrect NAV is published there can be quite a number of consequences. Not only does
an incorrect NAV cause additional work for the funds transfer agent and fund accountant,
but also the shareholders and the advisor are also affected. There can be serious reputational
issues for the promoter and investment manager of the funds. In addition, the stock exchange
or the regulatory body such as the Financial Regulator may need to be informed.
Consider the following consequences of an incorrect NAV.
Assume the NAV of a fund is overstated and a shareholder is making an investment into
the fund based on a fixed dollar amount. The shareholder will receive less shares than
they are entitled to at the time of their purchase. The shareholders and fund share
balances will need to be adjusted to take account of the corrected NAV. For example, the
NAV is incorrectly calculated to be Eur19.27 and should be Eur19.23. A shareholder
making a purchase of Eur1,000 would receive 51.89 shares (Eur1,000/Eur19.27) when
the correct shares received should be 52 (Eur1,000/19.23).
Assume the NAV of a fund is overstated and a shareholder is making an investment into
the fund based on shares purchased. The shareholder would have paid too much for the
shares purchased and would need to be reimbursed the dollar amount of the different.

93

ABCD

Assume the NAV is incorrectly calculated to be Eur19.27 and should be Eur19.23. A

shareholder pays Eur1,927 for 100 shares rather than Eur1,923 for 100 shares.
If the NAV is understated on a fund, a shareholder making an investment into the fund in
shares, or in dollars, would pay less for the shares, or receive too many shares. The fund
would have been diluted and will need to be made whole. Assume the NAV is incorrectly
calculated to be Eur19.20 and should be Eur19.23. A shareholder making a purchase of
100 shares would pay Eur1,920 rather than Eur1,923. A shareholder paying Eur1,000
would receive 52.083 shares (Eur1,000/19.20), when the correct share amount is 52.002
(Eur1,000/19.23).
If the NAV of a fund is overstated and a shareholder is redeeming out of the fund, the
shareholder will be overpaid causing dilution in the fund which will need to be
reimbursed. The NAV is incorrectly calculated to be Eur19.27 and should be Eur19.23.
A shareholder redeeming 500 shares will receive Eur9,635 (500 x Eur19.27) when the
correct amount is Eur9,615 (500 x Eur19.23).
Conversely, if the NAV on the fund is understated and a shareholder is redeeming out of
the fund, the shareholder will receive less money than he or she is entitled and will need
to be reimbursed. The NAV is incorrectly calculated to be Eur19.20 and should be
Eur19.23. A shareholder redeeming 500 shares will receive Eur9,600 (500 x Eur19.20)
rather than the correct amount of Eur9,615 (500 x Eur19.23).
In each of the above examples it was necessary to adjust the transfer agents and the
accounting records in order to process the correct NAV. The transfer agent will need to make
adjustments to each shareholder account involved over the period an incorrect NAV was
used.
In addition to the extra work involved in the reprocessing of shareholder accounts due to
incorrect NAV, shareholders opinions of the funds investment advisor may decline.
Shareholders may begin to question the integrity of future figures published by the fund and
may question the capabilities of the investment advisor.
The accounting agent may be subject to the financial liability of reimbursing the fund when
shareholders have been overpaid.
An incorrect NAV calculated may also result in incorrect financial statistics being distributed
to and released by reporting agencies. Reporting agencies collect various financial statistics

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for funds which they use to compute and publish performance data on the funds. The
agencies also publish fund ratings, where they compare or rate similar funds. Incorrect data
being released could result in a top performing fund being published as one of the worst
performing funds, or vice versa. Investors rely on published numbers as being accurate as
they use the numbers to make investment decisions.
Types of Controls
Due to the importance of the calculation and distribution of accurate NAVs, there are many
controls which can be implemented. There are broadly two different types of controls; high
level controls and low level controls.
Low level controls: these controls are preventative in nature and stop things going wrong.
Examples of such controls would be the preparation of bank, unit or holding
reconciliations, automatic computer totting of numbers in a spreadsheet, or signing trade
tickets.
High level controls: these are detective in nature and identify things that have gone
wrong. Such controls would include the review of reconciliations (performed by someone
else), price exception reports, or the senior managements review of monthly NAV
information.
Examples of some of the more common controls put in place around the production and
calculation of a NAV are as follows:
Pricing Tolerance Control
This control requires the fund accountant to verify and investigate any security price changes
over a specified tolerance from the prior days price. Typically, the verification is required
for positive or negative changes of around 5% or more for stocks and 1% or more for bond
prices. When a price is in breach of the limit, the accountant would verify the price change
using an alternative source and news stories on the security. This control is a useful method
which helps detect several potential problems such as improperly priced securities, securities
not priced and corporate actions overlooked.
On a fund basis the accountant could check the movement of the whole portfolio to a similar
fund or a suitable index.

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Sales/Purchases Price Check

This check compares the sales/purchases price of trades to market valuation for all additions
and deletions to the funds portfolio for the purpose of assessing the purchase and sale prices
for reasonableness, it also serves to aid in the detection of incorrect data being posted to the
fund. Any variances over set tolerance limits should be investigated.
Holdings Reconciliation
The funds portfolio holding per the accountants records should be reconciled in detail at
least monthly to the custodians records (and advisors, if possible). Some accounting agents
complete a total nominal holdings reconciliation on a daily basis.
This independent third party reconciliation control gives the accountant some assurance that
his records are correct and that no mis-communication has occurred.
Cash Reconciliation
This is a reconciliation of the accountants cash balances in each currency to the custodians
records.

It should be completed daily and it is essential to deal with all reconciling

differences as soon as possible.

Fund Share Control
The accountant should reconcile his total fund shares outstanding, unsettled fund share trades
and total distributions payable, if applicable to the transfer agents records on a daily basis.
This independent third party verification control is a simple but very effective check.
Income Verification
Due to the nature of the income stream of fixed income securities, a useful control is to
verify independently from the accounting system the daily income earned. In general this is
done by starting with the prior days income and adjusting for any changes such as trades
settling or interest rate changes, on that day. This control should detect incorrect recording
of the trade on the accounting system or any variable rate changes not booked etc.
Yield Change Check
This control is similar to the income verification control as it verifies the causes of the
changes to the yield on a particular day. This is particularly useful for money market funds.

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Chapter 10 - Irish Stock Exchange

10.1 Introduction
The Stock Exchange Act 1995 provides that no Stock Exchange can be established in the
State unless it has been approved by the Financial Regulator. The Irish Stock Exchange has
been approved by the Financial Regulator to carry out the activities of an approved stock
exchange.
The Irish Stock Exchange Limited is a company limited by guarantee under the Companies
Acts. The Exchange has a board of twelve directors, comprised of an independent chairman,
four co-opted directors representative of wider market interests, and seven directors elected
by member firms.
The Exchange lists a number of securities which can be traded on the Exchanges two
regulated markets which are:
The Official List
The Irish Enterprise Exchange (IEX), for small to medium size companies. This has
replaced the previous Exploration Securities Market (ESM) and the Developing
Companies Market (DCM) markets.
The main types of securities which can be traded on the Irish Stock Exchange include:
Corporate Securities equities, preference shares and corporate bonds
Irish Government Bonds
Exchange Traded Funds; the ISEQ 20 ETF plc, is an ETF that tracks 20 leading Irish
quoted companies
Covered Warrants
UCITS & Investment Funds
Specialist Securities

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10.2 Member firms

Member firms of the Irish Stock Exchange must be authorised by the Financial Regulator
and be approved by the Exchanges Admissions Committee prior to trading on the
Exchanges markets. Member firms do not have to be Irish resident but all member firms
must be approved by the Admissions Committee & must be regulated/authorised by the
relevant competent authority in their home state. The Irish Stock Exchange maintains a
register of authorised member firms.
The Financial Regulator has delegated the responsibility for monitoring Irish Stock
Exchange member firms compliance with conduct of business matters to the Irish Stock
Exchange and has approved the Exchanges Rulebook in this regard.
The Financial Regulator remains responsible for ensuring that member firms maintain
adequate capital, books and records including client monies, advertising and other matters.
To this end, the Financial Regulator currently applies the following Code and handbook
requirements to member firms:
Client Money Requirements for Stock Exchange Member Firms February 2004
Client Money Guidance Note February 2004
Handbook for Investment and Stockbroking Firms

10.3 Rules of the exchange

The rules which govern the relationship of member firms with the Irish Stock Exchange are
set out in The Rules of the Irish Stock Exchange, published by the Irish Stock Exchange.
These Rules outline how member firms should interact with their clients.
The Regulation Manager of the Irish Stock Exchange is responsible for monitoring member
firms compliance with the Exchanges Rulebook on an ongoing basis through surveillance
of the market and on site visits. The Exchange can impose disciplinary measures including
fines on member firms if they have been found to be in breach of the Rules.

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The Rulebook contains detailed conduct of business rules, for dealings by member firms
with their clients, as well as provisions related to:
Complaints
Membership
Individual Registration
Dealing and Reporting
Settlement Rules
Compliance and Discipline
Registered Representatives
Individuals who advise and execute orders for clients are referred to as Registered
Representatives and must meet fitness and probity standards and be suitable qualified and
approved by the Irish Stock Exchange. The Exchange maintains a list of such Registered
Representatives. Only Representatives Persons can advise on and execute orders for clients.
To become a Registered Representative in a member firm an individual must:
be an employees of the member firm;
undertake to commit no act or omission which places the member firm in breach of any of
the rules of the Stock Exchange, and
have completed the Irish Stock Exchange Registered Representatives examinations or
have been exempted by reason of seniority and exceptional experience.
Complaints
The Financial Regulator has delegated to the Irish Stock Exchange the role of investigating
complaints relating to member firms of the Exchange.
Complaints may be investigated by the Exchange if they relate to the following:
the continuing obligations of entities listed on the Exchange.
unusual trading or suspected cases of insider dealing. The Exchange has a statutory
obligation under Part V of the Companies Act, 1990 to investigate such matters.
a member firm and its dealings with its clients. If the complaint has been initially raised
with the member firm concerned and the investor is not satisfied with the member firms
decision or findings in relation to the matter, then the complaint may be referred to the

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Regulation Manager of the Exchange to investigate the matter independently of the

member firm.
Having considered a complaint, the Regulation Manager may:
caution the member firm and take no further action,
issue a direction which shall be binding on the member firm specifying action to be taken
by it to provide restitution to the complainant, or
if he is not satisfied the complainant has suffered a financial loss take no action against
the member firm in relation to the complaint, other than notify the member firm and the
complainant of his decision.
Alternatively, the Regulation Manager can refer the complaint to the Exchanges
Disciplinary Committee or impose a fine on the member firm.
Duty to notify the Financial Regulator
The Regulation Manager or the Chief Executive of the Stock Exchange must inform the
Financial Regulator immediately where, in their judgment, a situation has arisen or is likely
to arise either in relation to a member firm or in relation to the operation of the Irish Stock
Exchange:
where a serious breach of the Rules or a provision of the Stock Exchange Act has
occurred or is occurring:
where serious problems have arisen in relation to enforcing or monitoring compliance by
a member firm with conduct of business rules;
where a referral is made to the Exchanges Disciplinary Committee.
In addition to Exchange must report various matters to the Financial Regulator if they occur,
e.g.:
details of any rule breaches identified during site visits, and details of any action which
any member firm or registered representative has been requested to take as a result of
such matters;
details of any fines or penalties imposed on any member firm;
details of the nature of any complaint received against any member firm or Registered
Representative;
details of the performance of individual member firms in meeting settlement obligations.

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10.4 Insider dealing

What is insider dealing?
Insider dealing is the term used to describe dealing in a particular security by a person while
in possession of precise information that is not publicly available, but which if it was
publicly available would be likely to materially affect the price of that security, for their own
advantage. It can also include encouraging someone else to deal, e.g. spouse, relative,
friend, etc. Insider dealing is a criminal offence.
The primary Irish legislation prohibiting insider dealing is Part V of the Companies Act,
1990. The legislation prohibits individuals and companies who are connected with the
company from using non-public price-sensitive (inside) information to deal in securities of
that company.
Examples of the type of information that may be considered to be inside information
include prior knowledge of details of interim and final results, mergers, acquisitions and
takeovers, etc.
Duties and Obligations of the Irish Stock Exchange
The Irish Stock Exchange, through legislations undertaken by the Regulation Department,
has a statutory obligation to investigate dealings in Irish securities traded on the Exchange
that are potentially insider dealing.
Trading investigations are undertaken on a routine basis arising from Exchange reviews of
relevant company announcements and unusual price movements. Investigations may also be
initiated from reports of unusual trades from member firms, from the media or from
members of the public.
If it appears to the Exchange following its investigation that an offence under Part V of the
Act has been committed, there is a statutory duty on the Irish Stock Exchange to provide the
Director of Corporate Enforcement with a report of its findings.
The Director of Corporate Enforcement in turn refers relevant offences to the Director of
Public Prosecutions. The DPP is responsible for prosecuting offences under the Act.

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Market Abuse Regulations

The Market Abuse Regulations came into force on the 6th July 2005. They transpose an EU
Market Abuse Directive (2003/6) into Irish law. The term

market abuse is deemed to

include insider dealing and market manipulation in relation to financial instruments traded on
a regulated market in the EEA area, i.e. EU Member States + Norway, Lichtenstein and
Iceland.
The Regulations provide for the prevention, detection, investigation and sanctioning of
insider dealing and market manipulation.
Obligations imposed by the market Abuse Regulations include those on:
persons professionally arranging transactions to notify suspicious transactions to the
Financial Regulator;
issuers of financial instruments to publicly disclose inside information without delay;
issuers of financial instruments to draw up lists of persons with access to insider
information;
those involved in the management of issuers of financial instruments to comply with
notification rules regarding managers; transaction. (with effect from 1st October 2005);
persons, including the media and journalists, involved in the preparation and
dissemination of recommendations (including research) regarding the fair presentation of
research and the disclosure of conflicts of interests. (with effect from 1st October 2005)
The Financial Regulator has been appointed the competent authority for the purposes of the
Market Abuse Regulations; however certain duties have been delegated to the Irish Stock
Exchange by the Financial Regulator.

10.5 Prospectus Regulations

The Prospectus Regulations made by the Minister for Enterprise, Trade and Employment,
came into operation on 1 July 2005. The Financial Regulator has been appointed the
competent authority for the purpose of the Prospectus Regulations, but has delegated some of
its functions under these Regulations to the Irish Stock Exchange to carry out on its behalf.

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The Prospectus Regulations provide that persons who make an offer of securities to the
public or seek admission of securities to trading on an EEA regulated market (in Ireland, the
Irish Stock Exchange) to publish a prospectus which is subject to prior approval by the
competent authority (in Ireland, the Financial Regulator).
A person who has had a prospectus approved by the competent authority of their Home
Member State can, subject to notification procedures, offer securities to the public or seek
admission of securities to trading on a regulated market in other Member States of the EEA,
without having the prospectus approved by the competent authorities of the other Member
States.
So an Irish entity, who have a prospectus approved by the Financial Regulator, can seek
admission to have the security admitted to a Stock Exchange in another EU Member State.
The Financial Regulator has delegated certain tasks relating to the scrutiny of prospectuses to
the Irish Stock Exchange. However, approval of a prospectus rests with the Financial
Regulator.
The Prospectus Regulations also provide for a system for the investigation of potential
prescribed contraventions of the Regulations, in addition to enforcement action, including
administrative sanctions that can be imposed by the Financial Regulator.
Further information
Further information on the Irish Stock Exchange can be found on www.ise.ie

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Chapter 11 - Money Laundering and Know Your Client

11.1 What is money laundering?

Money Laundering is the term given to the way that criminals attempt to conceal the true
origin and ownership of the proceeds of their criminal activity. Criminals will attempt to use
the financial system to confer the appearance of legality on money procured by illegal
activity. Laundering is in fact, simply arranging for the traces of the origin of the criminal
cash to disappear.
The goal of a large number of criminals acts is to generate a profit for the individual or
group that carries out the act. Money laundering is the processing of these criminal proceeds
to disguise their illegal origin. This process is of critical importance, as it enables the
criminal to enjoy these profits without jeopardising their source.
Examples of illegal activities, which can lead to attempts to launder money would be:
Illegal arms sales
Terrorism
Smuggling
Drugs trafficking
Prostitution rings
Embezzlement
Insider trading Bribery
Computer fraud schemes
In recent years there has been a growing recognition that it is essential in the fight against
crime that criminals be prevented, wherever possible, from legitimising the proceeds of their
criminal activities by converting funds from dirty to clean. No one knows exactly how
much dirty money flows through the worlds financial system each year, but the amounts
are undoubtedly huge. It is estimated that about half of the laundered money arises from the
illegal trade in drugs, and the rest from other funds of other organised crime and terrorism.
The ability to launder the proceeds of criminal activity through the financial system is vital
to the success of criminal operations. Those involved are required to exploit the facilities of
the worlds financial institutions if they are to benefit from the proceeds of their activities.

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The increased integration of the worlds financial system and the removal of barriers to the
free movement of capital have enhanced the ease with which criminal money can be
laundered and have complicated the tracking process. Individual financial institutions which
become involved in money laundering will risk prosecution and the loss of their good market
reputation.

11.2 Stages of Money Laundering

There is no one-way of laundering money. Methods can range from the purchases and resale
of high-value items (e.g. houses, jewellery, cars etc.) to the passing on money through a
complex international web of legitimate businesses and shell companies, the laundering
process usually consists of the following three stages:
Placement
The placement phase is the one during which money is injected into the financial system.
This is a process by which cash is finally converted into a financial instrument. Many
techniques are used to provide the appropriate justification. One of the techniques involves
smurfing, which means many people carrying comparatively small sums of money, which
are converted into bank accounts. Smurfers may use a commercial intermediary and
camouflage strategies or create accounts with the complicity of a bank or at least a member
of the banks staff. In all of these techniques, the distinction between legal and illegal funds
can prove difficult to identify.
The placement stage is one of the most important stages in the process of money laundering
because of the obvious large amounts of cash, which are evident, and the general
vulnerability.
The Transfer Agent / Registrar is unlikely to be vulnerable at this stage. It is not normal
market practice to accept cash or travellers cheques as a payment medium for investments.
Layering
The middle stage of the laundering process is the one where traces of the true origin of the
money are washed out. The aim is to detach the funds from their original source and,
through a number of complex transactions, render the origins totally obscure in order to
disguise the audit trail. Bank monies will be used for all types of investments as well as
bank cheques and travellers cheques all of which can be converted into other financial
instruments such as stocks, shares, real estate and other similar assets.
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This pattern of switching, buying and selling is repeated over and over again. The electronic
transfer of money through various countries, which do not have strict controls will also serve
to obscure origins.
Transfer Agents/Registrars could be involved in this layering exercise through the
purchase of shares in funds and hence it is important that the necessary checks and
restrictions are carried out.
Integration
Integration is the final phase in the money laundering process during which the monies are
used for apparently profitable and respectable purposes. This is phase, which often involves
extremely complex economic and financial schemes, and by this time it will be exceptionally
difficult to reconstruct all the operations to prove the relationship between the original
criminal source of funds and the final legitimate proceeds. If the layering process was
successful, integration schemes place the laundered proceeds back into the economy with the
appearance of normal business funds.
These phases may occur separately, simultaneously or they may overlap. The methods used
to launder money will be dictated by the available laundering mechanisms and the
requirements of the criminal organisation.
An example of attempts to launder money would be as follows:
Placement stage

Layering stage

Integration stage

Cash paid into bank (sometimes

Wire transfers abroad (often

False loan repayments or

with staff complicity or mixed

using shell companies or funds

forged invoices used as

with proceeds of legitimate

disguised as proceeds of

cover for laundered money.

Business).

legitimate business).

Cash exported.

Cash deposited in overseas

Complex

banking system.

(both domestic and

web

international)
original

of

transfers

makes

source

of

virtually impossible.

Cash used to buy high valued

Resale of goods / assets

Income from property or

Goods, property or business

legitimate business asset

Assets.

appear clean.

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funds

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How financial institutions can combat money laundering

Institutions should at all times pay particular attention to the fundamental principle of good
business practice know your client. Having a sound knowledge of a customers business
and pattern of financial transactions and commitments is one of the best methods by which
financial institutions will recognise attempts at money laundering.

11.3 What is the Financial Action Task Force (FATF)?

www.fatf-gafi.org

The Financial Action Task Force on money laundering was established in 1989 by the G-7
Summit. Its main purpose was to develop a co-ordinated approach to combating money
laundering.
The FATF is an inter-governmental body, which develops and promotes policies to combat
money laundering. Its main goal is to generate the political support necessary to bring about
reforms in national and international legislation and regulation in this area.
The FATF drafted 40 recommendations, which set out the measures that governments should
take to implement comprehensive anti money laundering programmes. In June 2003 the
FATF agreed on a substantial revision of the Forty Recommendations (here after referred to
as the Recommendations) to take account of experience acquired and the enhanced measures
required to combat the phenomenon more effectively. The revised Recommendations now
apply not only to money laundering but also to terrorist financing, and when combined with
the Eight Special Recommendations on Terrorist Financing provide an enhanced,
comprehensive and consistent framework of measures for combating money laundering and
terrorist financing.
The FATF recognises that countries have diverse legal and financial systems and all countries
cannot take identical measures to achieve the common objective, especially over matters of
detail. The Recommendations therefore set minimum standards for action by countries to
implement the detail according to their particular circumstances and constitutional
frameworks. The Recommendations over all the measure that national systems should have
in place within their criminal justice and regulatory systems; the preventative measures to be
taken by financial institutions and certain other businesses and professions; and international
co-operation.

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The original FATF Recommendations were drawn up in 1990 as an initiative to combat the
misuse of financial systems by persons laundering drug money.

In 1996 the

Recommendations were revised for the first time to reflect evolving money laundering
typologies.

The 1996 Forty Recommendations have been endorsed by more than 130

countries and are the International anti-money laundering standard.

11.4 The Criminal Justice Act 1994

In line with the EU Council Directive (91/308/EEC) on prevention of the use of the financial
system for the purpose of money laundering and the Recommendations of the FATF, Ireland
drafted the criminal Justice Act 1994. As a result, the Irish law relating to money laundering
is principally contained in the Criminal Justice Act, 1994, which has been amended since
then by different legislation. The legislation deals with a number of issues:

a definition of what money laundering is.

imposition of measures on designated bodies to prevent and assist in the detection of

money laundering.

obligations on designated bodies to report to the Gardai and Revenue Commissioners,

suspicions of attempts to money launder.

obligations on designated bodies to report to the Gardai, any transaction with a state or
territorial unit within a state that is prescribed by the Minister for Justice.

it is an offence to tip off a person about a report made to the Gardai and Revenue
Commissioners, which could prejudice any investigation into such a report.

Definition of money laundering

Section 31 of the Criminal Justice Act 1994 defines the office of money laundering as
follows:
A person is guilty of money laundering if, knowing or believing that property is or
represents the proceeds of criminal conduct or being reckless as to whether it is or represents
such proceeds, the person, without lawful authority or excuse (the proof of which shall lie on
him or her)
(a)

converts, transfers or handles the property, or removes it from the State, with the
intention of:
(i)

concealing or disguising its true nature, source, location, disposition, movement

or ownership or any rights with respect to it, or

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(ii)

assisting another person to avoid prosecution for the criminal conduct

concerned, or

(iii)

avoiding the making of a confiscation order or a confiscation co-operation order

(within the meaning of section 46 of this Act) or frustrating its enforcement
against that person or another person,

(b)

conceals or disguises its true nature, source, location, disposition, movement or

ownership or any rights with respect to it, or

(c)

acquires, possesses or uses the property.

Financing terrorism
The Criminal Justice (Terrorist Offences) Act, 2005 has introduced the new offence of
financing terrorism. Some of the obligations on designated bodies below in relation to
detection of money laundering now also apply to the offence of financing terrorism.

Obligations on designated bodies

Obligations are imposed on designated bodies to prevent and assist in the detection of
money laundering and financing terrorism. These include:
obligation to establish the identity of the client;
obligation to retain records and documents;
obligation to adopt measures to prevent and detect money laundering and the offence of
financing terrorism;
obligation not to tip off clients about reports of suspicious transactions.
To train and educate staff
There is a wide range of financial institutions and bodies described as Designated bodies
for this purpose, the following is a list of some of these designated bodies under the Act
(Section 32(1):
Bank and Building societies
Money brokers
Life assurance companies
Providers of services in futures and options exchanges
An Post
Credit Unions

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Stockbrokers
Bureau de Change
The Minister for Justice has also prescribed other bodies to be designated bodies. Details
of which may be found in the Guidance Notes, pages 11 and 12.

Reporting suspicious transactions

Making a report
Designated bodies, including their directions, employees and officers, must make a report to
the Garda Siochana and the Revenue Commissioners where;
they suspect that an offence of financing terrorism has been or is being committed;
and/or
they suspect that an offence under the client identification requirements has been or is
being committed, e.g. an individual provides evidence of identity that proves to be fake;
a transaction with any State prescribed by the Minister for Finance as being a state which
has not in place adequate procedures for the detection of money laundering or financing
terrorism.
The term suspicious is not defined in relation to reporting suspicious transactions.
However, a suspicious transaction will often be one which is inconsistent with a customers
known, legitimate business or personal activities or with the normal business for that type of
account. Therefore, the first key to recognition is knowing enough about the customers
business to recognise that a transaction, or series of transactions, is unusual.
Tipping off
It is an offence to tip off anyone about:
any investigation into money laundering or financing terrorism;
any report made to the Gardai and Revenue about suspicions to money launder or finance
terrorism or failure to establish a clients identity.
The Legal Position
It is an offence to assist anyone whom you know or suspect to be laundering money
generated by crime.

Believing property to be, or represent another persons criminal

proceeds includes thinking that the property was, or probably represented, such proceeds.
This offence is punishable by up to fourteen years imprisonment and/or fine.

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It is an offence for a designated body to fail to take reasonable measures to establish the
identify of any person or third party, where it knows, or has reason to believe, that the person
to whom it proposes to provide the service is acting for a third party. This offence is
punishable by up to five years imprisonment and/or a fine.
Under the Act, designated bodies must retain copies of all materials used to identify a
customer. Records must be retained for a period of at least five years after the relationship
has ended. Documents relating to transactions must also be retained for at least five years
after the transaction has taken place. It is an offence for a designated body to fail to maintain
these records. This offence is punishable by up to five years /imprisonment and/or fine.

11.5 The Money Laundering Guidance Notes

The Money Laundering Steering Committee of the Irish Financial Services Regulatory
Authority (Financial Regulator), issued guidance notes for financial institutions these
guidance notes have been posted on moodle . The Guidance Notes, while not legally binding
may be taken into account in court proceedings. The Financial Regulator may also use the
Guidance Notes as a benchmark against which to access the compliance of institutions under
its supervision. Therefore, the Act and the Guidance Notes must be looked at together.
The Guidance Notices aim to explain the legislative provisions of The Criminal Justice Act,
1994 (the Act), keeping in line with:
The EU Council Directive (91/308/EEC) on prevention of the use of the financial system
for the purpose of money laundering
The Forty Recommendations of the Financial Action Task Force (FATF).
In particular, the relevance of the following sections of the Act to financial institutions and
their employees are explained:
Section 31 (amended by Section 21 of the Criminal Justice (Theft and Fraud Offences)
Act, 2001) sets out the offence of money laundering and broadly provides that a person is
guilty of money laundering if knowing, believing or being reckless as to whether property
is or represents the proceeds of criminal conduct he converts, transfers or handles the
property.
Section 32 (amended by Section 14 of the Criminal Justice (Miscellaneous Provisions)
Act, 1997) imposes obligations on a wide range of persons and bodies providing financial
services (designated bodies) to take certain measures (e.g. establishment of identify of
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customers and retention of documents and records of transactions) to prevent and assist in
the detection of money laundering.
Section 57 imposes obligations on designated bodies and their employees to report to the
Garda Siochana and the Revenue Commissioners suspicions that under Section 31 (the
offence of money laundering itself) or Section 32 (dealing with customer identification
and

record retention) an offence has been committed. Any such report will not be

treated as a breach of customer confidentiality as long as it is made in good faith.

Section 57(6) of the Act provides that, in the event of a prosecution, in determining
whether a designated body or a member of its staff has failed to make a report to the
Garda Siochana and the Revenue Commissioners as required by the Act, a court may take
account o f such Guidance Notes.
Section 57(A) (as inserted by Section 23 of the Criminal Justice (Theft and Fraud
Offences) Act, 2001) imposes an obligation on designated bodies to report to the Garda
Siochana any transaction connected with a state or territorial unit within a state that
stands designated by the Minster as not having in place adequate procedures for the
detection of money laundering.
Section 58 provides for various offences of prejudicing investigations under the Act
including an offence of tipping off a customer about whom a report has been made.

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Chapter 12 - Data Protection

12.1 Introduction
Financial service providers, like credit institution and insurance undertakings, use personal
data about their clients as part of their normal business activities.

Indeed it is not

conceivable that such entities could operate without accessing and processing personal data
about their clients, every day.
In disclosing and providing personal information to a financial services provider, most
clients would expect that:
their personal information would not be divulged to people who are not entitled to see it;
their personal information would only be used for the purpose for which it was obtained;
their contact details (name, address and telephone number) would not be passed on to
direct marketing companies or others and therefore they would not expect to receive a
flood of junk mail or, to be contacted by email or phone by people and entities they do not
know or have not dealt with;
their information stored is correct and up-to-date. For example, a person who has a life
assurance policy would be surprised if they received the death benefit under the policy
while they were still alive.

12.2 Data Protection Acts

The Data Protection Acts, 1988 to 2003, seek to protect the privacy of personal data in two
main ways:
by imposing certain restrictions on entities who process data, referred to as data
controllers, on how they obtain and use personal data and information.
by providing certain rights on individuals to access, correct inaccurate information or
have certain personal data and information removed, and the right to complain to the Data
Protection Commissioner.
The operation of the Acts is overseen and enforced by the Data Protection Commissioner.

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What does the Data protection legislation cover?

The Data Protections Acts 1988 and 2003 (the Acts) impose obligations on data controllers
and data processors in respect of the processing of personal data. Personal data means data
relating to a living individual who is or can be identified from the data in conjunction with
other information that is in, or is likely to come into, the possession of the data controller.
Accordingly, data protection legislation applies to information gathered in respect of an
individual and not to information obtained in respect of a corporate entity, partnership, trust
or other similar entity.
A data controller means a person who, either alone or with others, controls the contents
and use of personal data. Therefore, it is likely that a fund established as an investment
company or the manager of a unit trust would be considered to be a data controller. A data
processor means a person who processes personal data on behalf of a data controller. This
could include delegates of an investment fund, such as an administrator or a distributor to
whom the responsibility for receiving and/or processing applications for shares/units in a
fund has been delegated where such applications include information relating to a living
individual.
The Data Protection Principles
The Act provides that all data controllers must comply with the following principles in
respect of personal data kept by them *the Data Protection Principles):
Information must be obtained and processed fairly.

Identifying certain information

(including the identity of the data controller and the purposes for which the data is
processed) which must be given to the data subject, whether such information is obtained
directly or indirectly from the data subject, otherwise the personal data will not be treated
as having been processed fairly (the Data Protection Act 1988 was previously silent on
this)
It must be kept only for one or more specified and lawful purposes
It may be used and disclosed in ways compatible with the specified purposes
It must be kept safe and secure
It must be kept accurate and up to date
The data controller must ensure that the data is adequate, relevant and not excessive
It must be retained for no longer than is necessary for the specified purposes
A copy of a persons personal data must be given to that person on request

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Data processors must comply with the security principle (i.e. keeping information safe
and secure)
Therefore, they must ensure that there are appropriate security and archiving measures in
place with regard to the personal data they process on behalf of data controllers.
These principles are binding on every data controller. Any failure to observe them is a
breach of the Act. A data controller found guilty of an offence under the Acts can be fined
amounts up to 100,000, on conviction and/or may be ordered to delete all or part of the
database.
Direct Marketing
There is a National Directory Database, to which individuals can apply to indicate that they
do not wish to receive unsolicited telephone calls, faxes or emails. Unlisted telephone
numbers are automatically assumed to not wish to receive unsolicited telephone calls. Direct
marketers must consult this National Directory Database and cannot make an unsolicited
telephone call, fax or email to phone numbers or accounts on this list.
Any person, including a data controller, cannot make an unsolicited call to an individual,
using automated calling machines, fax or email, unless that individual has given specific
permission to the entity making the unsolicited call.
Individuals also have a right to instruct a data controller not to use their personal data for
direct marketing purposes; the data controller must comply with this instruction within 40
days.
For this purpose direct marketing is defined as: direct mailing other than direct mailing
carried out in the course of political activities by a political party or its members, or a body
established by or under statute or a candidate for election to, or a holder of, elective
political office
The Office of the Data Protection Commissioner
The Data Protection Commissioner is the person responsible for the enforcement of the Acts.
Although all data controllers must comply with the Data Protection Principles, only certain
data controllers are required to register with the data Protection Commissioner. The

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registration process is relatively straightforward; however, the cost of registration varies

depending on the number of employees of the data controller.
The categories of data controller required to register with the Data Protection Commissioner
is currently under review and new regulations dealing with this are expected to come into
force in the next few months. It remains to be seen if investment funds will be expressly
included in the categories of data controller required to register. Data processors whose
business consists wholly or partly of processing personal data on behalf of data controllers
are already required to register with the Data Protection commissioner.
Making a complaint to the Data Protection Commissioner
If an individual feels that a data controller is not meeting their data protection obligations to
the individual and if the individual is not satisfied with their response to the individuals
complaint, then the individual may complain to the Data Protection Commissioner.
If the Commissioner cannot arrange an amicable resolution of the individuals complaint
about the data controller, the Commissioner can then investigate the complaint. If the
Commission upholds the complaint, he has legal powers to enforce compliance by the data
controller.
The Commissioner cannot award compensation. However Section 7 of the Data Protection
Act 1988 states that a data controller owes a duty of care to individuals with regard to how
the data controller collects and uses personal information. Individuals could therefore,
potentially sue a data controller for damages if the data controller had not fully complied
with the Data Protection Act obligations and duties.

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Chapter 13 Fund Valuation

Fund Valuation
After studying this Chapter, you should be able to:
Examine the responsibilities of the Fund Administrator in relation to the valuation of an
Investment fund.
Outline the valuation process for calculating the Net Asset Value (NAV) of an Investment
Fund.
Describe the process for the recording and settlement of Trades.
Identify the main pricing sources of investment instruments for listed securities, unlisted
securities, foreign currency and derivatives.

13.1 Introduction to Valuations

The term Fund Administrator has two meanings in the context of the Investment funds
business.

The first describes a financial institution, which has been engaged by an

investment fund. The second is the job title of the individual who carries out those duties for
the financial institution. In the Irish financial services industry the duties of the Fund
Administrator as an institution are similar regardless of the company concerned. However
there may be a difference of emphasis in the job responsibilities of the Fund Administrator as
an individual.
Responsibilities of the Fund Administrator

Calculation of the Net Asset Valuation

Maintaining the books of record and documentary

support
Preparation of annual and semi-annual accounts
Assisting the funds auditors in the audit of year end

accounts
Preparation of reconciliations and documents
Financial Regulator reporting

The fund administrator has been described as the Historian of the Fund. The administrator
records all of the transactions that occur within the fund in a financially meaningful way.
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They provide investors with an independently calculated measure of their investments value
(the NAV).
Their work is regularly assessed by audit firms and regulatory authorities. Investors are
entitled to view the books of account at any time. This work is the recording of a type of
financial history.
In most reputable organisations this history is recorded on a computer system specifically
designed for the fund administration process. Without such systems the production of timely
and accurate valuations and accounts would not be possible.
A fund administration computer system is an administrators primary tool and computer
literacy and an ability to understand processing systems are therefore essential skills to
practitioners in the industry. However, as systems differ in each organisation the practical
aspects of systems are not addressed in this document.

13.2 Valuation
These following chapters describe the various components of the Net Asset Valuation and the
steps required to achieve that goal. We have described the types of instruments in which a
fund may invest and now we deal with the valuation of these instruments. We then explore
some of the options available to a company when restructuring its share capital and the effect
that such a restructuring can have on a fund which holds shares in this company. The income
and expenses that a fund may earn/pay are then dealt with and finally we detail the types of
controls which the fund administrator would typically use in order to ensure an accurate Net
Asset Value calculation. It should be stressed, however, that for each particular fund, the
valuation and general accounting policies will be detailed in that funds prospectus. This
chapter deals with the more frequently used policies.
The process of calculating the NAV can be described as all or nothing. The administrator is
heading towards a single number, the net asset value per unit, which is an accurate estimate
of the realisable value of an investors proportional ownership in a fund. The administrator
can afford no oversight or omission in that process. To do so would penalise or unfairly
reward shareholders and misrepresent the value of their investment.

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Recording and Settlement of Trades

For Net Asset Value calculation purposes, the accounting agent will receive the portfolio
trading activity from the advisor and generally reflect it on the accounting records on the
next business day following trade date (trade date plus one) or on the settlement of the
transaction (settlement day).
Trade date being the date on which the trade is transacted between both parties. Settlement
date being the date on which security transactions are settled by delivering or receiving
securities and receiving or paying cash.
The following diagram shows the information flows:

Trade Ticket

Trade Ticket

Investment
Advisor
Confirmation

Direct
Details

Fund
Accountant

Confirmation

Broker

Reconciliation
Delivery of Security

Custodian

Pricing Sources
Many securities held in the portfolio of a fund have a number of possible valuation prices
and sources. The specific pricing policy and procedures are to be found in the prospectus of
the fund. The administrators will implement this policy by obtaining the appropriate security
prices from, ideally, independent sources, i.e. independent of the fund manager.
Most accounting departments electronically import security prices, used in valuing portfolio
securities from outside pricing sources.

These outside pricing sources would in turn

normally receive electronic feeds directly from the various stock exchanges. The more
widely known pricing vendors would include Reuters, Bloomberg, Extel, Muller, IDC, etc.

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The specific methods used by the pricing services to determine security prices vary from
source to source and from security class to security class. In general, security values are
valued through one of two basic approaches:
Security prices are based on actual trading data for the issue being valued.
Security prices are valued using a model or methodology which estimates a value based
on actual trading history of similar securities.
The likelihood of error by pricing services depends directly on both the concentration and
the depth of the market. There is less likelihood of error for securities whose market data
can be obtained electronically, as compared to security prices that must be manually entered
into the computers by pricing services personnel.

13.3 Pricing Investment Instruments

When it comes to pricing or valuing an investment instrument, the question arises as to how
do we determine what a fair value is. Is the security listed, is there an active market in the
security, are there any restrictions on the disposition of the security? To answer these and
other questions, we will separate the types of instruments into suitable categories and deal
with each separately.
Listed Securities
A Listed Security is any security that trades on a listed exchange (e.g. New York Stock
Exchange, London Stock Exchange, etc). Both equities and bonds can be listed on an
exchange.
Ordinarily, little difficulty should be experienced in valuing securities listed or traded on a
stock exchange, however there are various prices that could be used for valuation purposes
as follows: -

Last Price:

This is the closing price of a security traded that day.

Bid Price:

The highest declared price a potential buyer is willing to pay for a

security at a particular time.

Ask Price:

A potential sellers lowest declared price for a security.

Mean/Mid Price:

The average of the bid and ask price for a security.

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Typically if a security is traded on the valuation date, the last quoted sale price is generally
used. In the case of securities listed on more than one exchange, the last quoted sale price up
to the time of valuation, on the exchange on which the security is principally traded would be
used or, if there were no sales on that exchange on the valuation date, the last quoted sale
price up to the time of valuation, on the other exchanges would be used.
If there was no sale on the valuation date but the bid and ask prices are available, the
valuation in such circumstances should be within the range of these quoted prices. Some
funds use the bid price, others use the mean of the bid and ask prices, and still others use a
valuation within the range considered best to represent value in the circumstances; as long as
these policies are applied acceptable, to use the ask price alone. Where, on the valuation
date, only a bid price or ask price is quoted or the spread between bid and ask prices is
substantial, quotations for several days should be reviewed.
If sales have been infrequent or there is a thin market in the security, further consideration
should be given to whether market quotations are readily available. If it is decided that they
are not readily available, an alternative method of valuation should be used.
Each funds pricing policy will be detailed in its prospectus or offering memorandum.
Unlisted Securities
An Unlisted Security is a security that trades over the counter i.e. not on an organised
exchange.
Quotations are available from various sources for most unlisted securities traded regularly in
the over-the-counter market. These quotations generally are in the form of inter-dealer bid
and ask prices. Because of the multiple sources, a fund frequently has a greater number of
options open to it in valuing securities traded in the over-the-counter market than it does in
valuing listed securities. A fund may adopt a policy of using a mean of the bid prices, or of
the bid and ask prices or of the prices of a representative selection of broker-dealers quoting
on a particular security; or it may use a valuation within the range of bid and ask prices
considered best to represent value in the circumstances. Again, any of these methods are
acceptable if consistently applied and the use of ask prices alone would not normally be
considered best practice.
Ordinarily, quotations for a security should be obtained from more than one broker-dealer,
particularly if quotations are available only from broker-dealers not known to be established
market-makers for that security, and quotations for several days should be reviewed. If the
validity of the quotations appears to be questionable, or if the number of quotations is such

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as to indicate that there is a thin market in the security, further consideration should be given
as to whether an alternative method of valuation should be used.
There is no single standard for determining the fair value of a security, if market quotations
are not readily available. As a general principal, the current fair value of an issue of
securities would appear to be the amount the owner might reasonably expect to receive for
them upon their current sale. Methods which are in accordance with this principle may, for
example, be based on a multiple of earnings, or a discount from market of a similar freely
traded security, or yield to maturity with respect to debt issues, or a discounted cashflow
method, or combination of these and other methods. Some of the general factors that should
be considered in determining a valuation method for an individual issue of securities include:
1) The fundamental analytical data relating to the investment,
2) The nature and duration of restrictions on the disposition of the securities, and
3) An evaluation of the forces which influence the market in which these securities are
purchased and sold.
Among the more specific factors which should be considered are:
a)
b)
c)
d)
e)

Type of security,
Financial statements,
Cost of date of purchase,
Size of holding,
Discount from the market value of unrestricted securities of the same class at the time of

f)
g)
h)
i)

purchase,
Special reports prepared by analysts,
Information as to any transactions or offers with respect to the security,
The existence of merger proposals or tender offers affecting the securities price,
Price and extent of public trading in similar securities of the issuer or comparable
companies.

The information so considered together with, to the extent practicable, judgement factors
considered should be clearly documented.
Short Term Securities
Fixed income securities with the number of days to maturity being less than sixty would
normally be considered as Short Term Securities.
Short Term Securities would normally be valued at par of if issued at a discount, at amortised
cost.
Amortised cost can be defined as the original cost plus or minus a proportion of any market
premium or discount been allocated such that the full premium / discount will have to be
allocated at maturity.
Amortisation will be dealt with later.

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Chapter 14 Accounting for Share Capital

14.1 Accounting for Share Capital
After studying this Chapter, you should be able to:
Identify the accounting entries for Subscriptions / Creations to an Investment Fund.
Outline the different types of distribution policies for Investment Funds.
Examine the process for a dividend re-investment.
Identify the accounting entries for Redemptions / Liquidations from a fund.
An individual wishing to invest a sum of money in a particular fund or to subscribe for a
certain number of shares in a particular fund will contact a transfer agent. Based on the Net
Asset Value (NAV) per share of the fund on that date the individual will pay a certain sum of
money to the transfer agent and in return he/she becomes the registered owner of a specified
number of shares in the fund. The transfer agent will report this activity to the fund and will
transfer the proceeds to the funds bank account.
This section deals with the accounting in the funds accounts for the subscriptions to the fund
(shares and money), the redemptions from a fund (shares and money) and the shareholders
options with regard to distributions from the fund.
Subscriptions/Creations
The transfer agent prepares a contract note which gives details of the new shares to be issued
in the fund and the cash being subscribed for these shares. Settlement of the subscription
proceeds is usually made some days later.
Subscriptions are the amounts invested by the shareholders and therefore form the capital of
the fund.
The accounting entries to record a subscription of money to the fund:
Dr

Amounts receivable for shares issued

Cr

Capital Subscribed

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On advice of receipt of subscription proceeds from the transfer agent:

Dr

Bank
Cr

Amounts receivable for shares issued.

The number of shares in issue in the fund increases. The total number of shares in issue is
used to calculate the NAV per share (i.e. total net asset value of the fund in cash terms
divided by the total number of shares in issue gives NAV per share).
Example Subscriptions
On 3 March 2008 Mr X subscribes for 10,000 shares in ABC Fund. The NAV per share of
ABC Fund at 3 March 2008 is 1.05. Settlement must be made on 9 March 2008.
The transfer agent will issue a contract note to Mr X advising him that he was been issued
with 10,000 shares in ABC Fund and that settlement of 10,500 must be made on or before 9
March 2008.
Accounting Entries in the funds accounts
On issue date, 3/3/08
Dr

Amount receivable for shares issued

Cr

10,500

Capital subscribed

10,500

On settlement date, 9/3/08

Dr

Bank
Cr

10,500
Amount receivable for shares issued

10,500

The number of shares increases by 10,000 with effect from 3/3/08.

The fund manager now has 10,500 at his disposal and he will use this in order to increase
the value of the fund (by investing in equities, bonds, etc). Mr X will be expecting the NAV
per share of ABC Fund to rise from its current NAV of 1.05. This is not guaranteed and
investors should be aware when making such investments that the NAV per share of the fund
may fall as well as rise and the investor may not get back his original investment.

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14.2 Distributors
Certain funds are set up with the intention of distributing profits by way of dividend to their
shareholders. Such distributors can be made annually, semi annually, quarterly etc. The
profits available for distribution will differ from fund to fund. One fund may only distribute
net income (being dividend and interest income less expenses), another fund might distribute
net income plus net realised gains. Another, more aggressive fund, might also distribute net
unrealised gains.
The distribution policy of a fund will be detailed in the Prospectus or Offering Document of
the fund.
In common with regular equity investments a fund will declare a dividend on one day, the
ex-dividend date and the physical payment will be made on a later date. Investors who have
acquired shares in the fund before ex date will be entitled to receive the dividend, those
purchasing shares on ex date or later will not. The NAV per share will drop in value on ex
date by approximately the amount of the dividend.
The accounting entries to record the distribution of profits from the fund
On ex date
Dr

Dividends Paid and Payable

Profit & Loss a/c

Cr

Balance Sheet Creditor

Dividends Payable

On pay date
Dr

Dividends Payable
Cr

Balance Sheet Creditor

Bank

Balance Sheet Asset

Example: Distribution
ABC Fund declares the following dividend
Dividend:

0.01 per share

Ex date:

5 May 2008

Pay date:

25 May 2008

Number of shares in issue:

596,650

Dividend to be paid on 25 May 5,966.50 (596,650 shares x 0.01)

Accounting Entries

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On ex date, 5/5/08
Dr

Dividends paid and payable

Cr

5,966.50

Dividends Payable

5,966.50

On pay date, 25/5/08

Dr

Dividends Payable
Cr

5,966.50

Bank

5,966.50

14.3 Dividend Reinvestment

When a fund declares a dividend the shareholders usually have the option of taking the cash
dividend or reinvesting this amount and receiving additional shares in the fund. This is
referred to as a dividend reinvestment.
The accounting entries to record a dividend reinvestment are as follows:
On ex date
Dr

Dividend paid and payable

Cr

Dividends payable

On pay date
Dr

Dividends payable
Cr

Capital Subscribed

The number of shares in issue in the fund will be increased on pay date.
Example: Dividend Reinvestment
ABC Funds distribution payable on 25 May, assume the holders of 120,000 shares opt for
dividend reinvestment rather than the cash dividend.

Total Dividend Payable

5,966.50

Split as follows
Cash dividend

4,766.50 (476,650 x 0.01)

Dividend Reinvestment

1,200,00 (120,000 shares x 0.01)

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5,966.50

Dr

Dividends paid and payable

Cr

5,966.50

Dividends payable

5,966.50

On pay date, 25/5/08

Dr

Dividends payable

5,966.50

Cr

Bank

4,766.50

Cr

Capital Subscribed

1,200,00

The NAV per share of ABC Fund on 25 May 2008 is 1.07 therefore 1,121.50 shares will
be issued for the 1,200 reinvested. These 1,121.50 shares will be added to the total
number of shares in issue in the fund in order to calculate the NAV per share on 26 May
2008.

14.4 Redemptions/Liquidations
When a shareholder wishes to redeem his/her holding of shares in a fund he must advise the
transfer agent. The shares will be redeemed at the NAV per share prevailing on that date. A
contract note is prepared which details the number of shares to be redeemed together with
the redemption proceeds. Settlement is generally made some days later.
The accounting entries to record the redemption are:
Dr

Capital Subscribed
Cr

Amount payable for shares redeemed

On advice of settlement
Dr

Amounts payable for shares redeemed

Cr

Bank

Examples: Redemptions
On 6 June 2008 Mr X wishes to redeem his holding of 10,000 shares in ABC Fund. The
NAV per share on 6 June is 1.078. Settlement is to be made on 12 June 2008.
Accounting Entries
On redemption date, 6/6/08
Dr

Capital Subscribed
Cr

10,780

Amounts payable for shares redeemed 10,780

On settlement date, 12/6/08

Dr

Amounts payable for shares redeemed

Cr

Bank

10,780
10,780

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The number of shares in issue in the fund will be reduced by 10,000 with effect from 7 June
2008.

Chapter 15 - The Custodian

After studying this Chapter, you should be able to:
Explain Custody, outlining why a custodian would be appointed.
Describe the roles of the Domestic and Global Custodian.
Discuss the stages involved in selecting a Custodian, examining the documentation to be
completed when appointing a Custodian.
Illustrate the types of Custody Fees applied.
Identify the driving forces impacting the custody business.
Discuss the role of Central Securities Depositories (CSDs).

15.1 What is Custody?

Thirty years ago when the phrase Global Custody first applied, it meant little more than
banks being able to lock up valuable assets in a safe. Today, Global Custody takes on a
different meaning and as defined by the ISSA, The international Society of Securities
Administrators, A Global Custodian provides its clients with multi currency custody,
settlement and reporting and currency and encompasses all classes of financial instruments.
For example, if Simon Jones, based in the United States, invests in assets in France, US,
Germany, and Japan, then he will want to appoint a Custodian who will have the facility to
hold the assets in the respective countries, on his behalf. Global custody has evolved for a
passive safekeeping function to an active, participative partnership with the fund manager
and the investor.
Before going into the role of the Custodian, it should be noted that term Custodian and
Trustee are often confused. Generally, there is little difference between the functions
carried out by a Custodian or a Trustee, where it is appointed to act on behalf of an Irish
regulated structure. It will depend on the funds structure before either one or other is to be
appointed, for example a Unit Trust will always appoint a trustee where as Investment
Company structure will appoint a Custodian.
The Custodian/Trustee is regulated by the Financial Regulator through the Financial
Regulator Notices which outline the minimum obligations to be performed. As the
differences between the Trustee and Custodian are minimal, the Financial Regulator notices

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simply refer to the Trustee function which is stated to include the Custodian function.
Therefore, where a Custodian and a Trustee is appointed by an Irish regulated structure, the
Trustee will oversee the adherence of the fund to the pertinent regulations, whilst the
Custodian will perform the asset-safekeeping and trade settlement roles. Where a custodian
is appointed by another custodian who is responsible for carrying out the fiduciary role on
behalf of an Irish regulated fund structure, this third-party or sub custodian does not carry
out the fiduciary role. The obligations of the Trustee are outlined in detail in Chapter 6.
A UCITS fund refers to one that is authorised by the Financial Regulator of Ireland which
may be offered for sale to members of the public in the other member states of the European
Union, without the requirement for further authorisation in those other countries. The UCITS
fund must comply with marketing and advertising regulations, applicable to local UCITS
funds established in those other member states. The UCITS fund may be constituted as:
a)

Unit Trusts, where the fund is constituted by a trust deed, the assets are held by a
custodian or trustee, and the unit trust is managed by either public or private

management companies which must be incorporated in the EU.

b) Investment Companies
Variable Capital investment companies which are generally registered as public
limited companies, or (in less frequent cases) fixed capital investment companies
c)

which are registered as Public Limited Companies

Common Contractual Funds
A legal structure used by multi-national companies to pool their employee pension
funds from across the world, into a single tax-efficient structure.

A non-UCITS fund refers to funds established in Ireland which do not benefit from the same
marketing advantages as a UCITS fund but which are subject to more flexible investment
restrictions. The funds can be established as open ended investment companies, as unit trusts
or as a Common Contractual Fund.

15.2 Domestic & Global Custody

Domestic Custody
Domestic Custody relates to a customer investing in assets in the domestic or local
marketplace, e.g. an Irish investor investing in Irish assets will settle the securities with an
Irish custodian, known as the domestic custodian.

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Domestic Custody
Irish Investor
Gilts

Equities

Investment
Settlement

Irish or
Domestic Custodian

Global Custody
Global Custody relates to a customer investing in assets in various markets outside the
customer's domicile, e.g. an Irish investor investing .in US Assets, European Assets etc. This
investment can also be described as a Cross-border investment which relates to the trading
of foreign securities either in the local marketplace between two parties, or in the foreign
market place between a local party and an overseas party.
Direct Custody
When appointing a custodian, a customer can appoint a Direct Custodian. A direct, or local,
custodian operates from the country of investment. An example of this would be a custodian
based in Germany for German securities. The investor appoints a custodian in each market
that he has Investments in. In appointing a direct custodian, the investor has the
responsibility of analysing credit and operational risks in each market and needs to have a
thorough understanding of each custodians capabilities. The customer must deal direct with
each custodian when settling investments in the relevant market.
Global Custodian
A global custodian offers services in all markets in which the investor wishes to invest. The
global custodian appoints a sub-custodian in each market. The investor deals directly with
the global custodian who, in turn, deals with the various sub-custodians appointed for each
market. The customer has the advantage of having only one relationship to manage and
problems such as differences in time zone and language are eliminated by going through the
global custodian.
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The Sub-Custodian Network

The global custodian or the regional custodian will appoint a network of sub-custodians, also
referred to as Agents to cater for markets that its investors are investing in. Each subcustodian provides domestic custody in their own country. The global custodian may use its
own branches if they already exist to provide a custody service in the particular market
place. If a branch does not exist in the market, the global custodian must select a third party
sub-custodian. In selecting a sub-custodian, a rigorous selection process prior to appointment
is carried out. This process includes;

In-depth research into the market and on-site visits;

Quality and range of services provided;
Credit rating of the sub-custodian;
Technology capabilities;
Management commitment, etc.

As stated in the Financial Regulator Notices, the following must be complied with.
The trustee must exercise care and diligence in choosing and appointing a third party as
a safekeeping agent so as to ensure that the third party has and maintains the expertise,
competence and standing appropriate to discharge the responsibilities concerned. The
trustee must maintain an appropriate level of supervision over the safe-keeping agent and
make appropriate enquiries from time to time to confirm that the obligations of the agent
continue to be competently discharged.
The trustee must
- ensure that there is legal separation of non-cash assets held under custody and that such
assets are held on a fiduciary basis. In jurisdictions where fiduciary duties are not
recognised, the trustee must ensure that the legal entitlement of the scheme to the assets
is assured.
- maintain appropriate internal control systems to ensure that records clearly identify the
nature and amount of all assets under custody, the- ownership of each asset and where
documents of title to that asset are located.
Where the trustee utilises the services of a sub-custodian, the trustee must ensure that these
standards are maintained by the sub-custodian.

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Where the trustee utilises the services of a global sub-custodian the trustee must ensure that
- the non-cash assets are held on a fiduciary basis by the global sub-custodian network of
custodial agents. This should be confirmed by those agents on a regular basis;
- the trustee must maintain records of the location and amounts of all securities held by
each of the custodian agents.
- the relationship between the trustee and the global sub-custodian should be set out in a
formal contract between the two entities.
As can be seen from the above Notices, it is important that the custodian / trustee monitor the
sub-custodians on a regular basis. This can be done by
1. Ensuring that the assets are held correctly by the sub custodian and in the correct name.
2. Receiving regular statements and ensuring they are correct. This is normally done on a
monthly basis.
3. Performing service reviews with the sub-custodian, usually on a semi annual or an annual
basis.

15.3 Prime Brokers (Hedge Funds)

Due to the diverse nature of instruments within hedge funds, hedge fund managers often
trade with a number of brokers who specialise in certain types of securities. The fund's Prime
Broker (if they have designated one) provides a consolidation service, which means that
executing brokers are instructed to settle all trades with this prime broker. This Simplifies
trade settlement and reporting as all trade information is centralised with one broker. The
prime broker's role has evolved with the growth of the hedge fund industry and it provides a
number of other ancillary services that may include; custody of the securities, lending of
securities for short sales, providing margin financing as well as providing back office
technology and reporting.

15.4 Selecting a Custodian

When selecting a custodian, the client will want to find out as much information as possible
about each custodian in order to eventually appoint one. This can be done in a number of
ways:
Independent surveys: Surveys carried out by consultants and custody related
publications try to measure how effective a custodian is, the quality of service being
provided and the level of client satisfaction. These surveys (such- as the annual survey
carried out by Global Custodian magazine) provide a guide to the investor on the

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strengths and weaknesses of the various custodians as well as the trends in the custody
industry.
Meeting directly with each custodian to investigate what services they provide, or
Request for Proposal (RFP). The RFP is an information gathering exercise designed to
provide clients with, an overview of the services the custodian can provide.
Typically, the client will provide information about themselves to the custodian on the RFP,
such as
The type of funds that the client seeks custody for;
The number of funds the client is seeking custody for;
The number of lines of assets;
The types of assets in which the fund will invest;
A list of markets that the funds are invested in;
Transaction volumes;
The information requested from the custodian by the client will typically include the
following:
Background - What the custodian's credit rating is, the types of business provided, the
level of resources dedicated to each business;
Market Information - What the settlement capabilities are for each market method of
instruction used, timeframes for instructions, what the sub custodian network consists of;
Administration - Safekeeping, Income Collection process, Corporate Action process,
Tax reclamation process;
Cash Management - What the foreign exchange capability is, what the interest rate policy
on currency accounts is, whether the custodian is capable of offering conversion of
income to foreign currency;
Reporting - What types of reports are available, the frequency and the method of receipt
(hard copy or electronic);
Technology - overview of systems capabilities, what interfaces are available between the
client and the custodian;
Pricing structure - breakdown of fees for services provided, frequency of billing;
Contingency - What the recovery plan Is in case of disaster;
Service - How flexible & responsive service is.

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The RFP process is a long detailed process which eliminates the weaker service providers
and highlights the more suitable candidates. The RFP acts as an initial step towards the
selection process. Answers contained within the RFP would not necessarily be enough to
justify choosing a custodian.
The next stage of the process is a meeting between the client and the prospective custodian.
The outcome of the R~P will be discussed as well as any other specific areas that require
investigation to satisfy the client that the custodian's services are the best for their needs.
This stage can take several meetings and negotiation between both parties. Often the client
will make several visits to the Custodian's offices where he will meet management,
administration and systems staff.
Documentation
Once a client has made the decision to appoint a custodian, both parties will complete and
sign various documents which need to be put in place with the Custodian/Trustee.
Some documentation differs in accordance with the vehicle type, i.e. a unit trust or an
investment company. The following table aims to outline the principal documentation
required. Both the client and the custodian will sign certain documents such as the Custody
Agreement or Trust Deed.

Custody Agreement
Trust Deed
Memorandum and Articles of
Association / Board
Resolution
Mandates
Fee Agreement
Electronic Banking Mandate
Tax Questionnaire
Prospectus
Annual Report
Financial Regulator letter of
Authorisation

DOCUMENTATION
Company
X

Unit Trust
X

X
X
X
X
X
X
X
X

X
X
X
X
X
X
X

Custody Agreement
The custody agreement between the client and the Custodian will include the following:
Circumstances where the custodian is permitted to transfer away the assets of the fund.
Circumstances where the custodian is allowed to payout cash belonging to the fund.

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Circumstances (if any) where the custodian is entitled to act without receiving proper
instructions.
A list of procedural requirements to ensure the authenticity of instructions to the
custodian (usually called "Proper Instructions) which the Custodian is able to act on.
(e.g. do the instructions need to be written or oral? Who can give the instruction).
The amount of fees payable and provisions for the payment of expenses by the fund.

Circumstances where the custodian will not be liable for losses suffered by the fund in
the event of loss or damage to the assets in the care of the custodian.

Provision for the appointment of sub-custodians.

Details of circumstances when the agreement can be terminated.
How to deal with conflicts between the custodian's own interests and the interests of the
fund and its investor.
Trust Deed
If a Unit Trust structure is required, It will be constituted by a Trust Deed between the
Trustee and the Management Company of the trust. The Trust Deed sets out the various rules
of the scheme and regulates the relationship between the Trustee, the Management Company
and the Unitholders. The unitholders do not sign the Deed but can see the main points in the
Prospectus of the trust.
Memorandum & Articles of Association
If an Investment Company structure is required, it will be constituted by the Memorandum
&. Articles of Association which outlines the objectives of the company and how the
company's affairs are to be managed.
Mandates
This will outline a list of requirements for giving instructions to the custodian before the
instructions will be regarded as "proper instructions" (e.g. written or oral). The list will
outline who Is authorised to give instructions and to what level. The authorised signatory list
is normally supported by a Board Resolution.
Fee Agreement
The fee agreement will cover what charges are made to the client for the various services
provided by the custodian. The type of fees charged is discussed further In section 2.5.

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Prospectus
The prospectus describes the fund to potential investors and must be made available to each
investor before an application is made for shares/units in a scheme. The prospectus outlines
the- fund's investment objectives, policies and restrictions; procedures for the subscription
and redemption of shares or units; the method of calculation of the net asset value of the
fund. The prospectus also outlines expenses of the fund which includes the Trustee Fee. The
prospectus must be offered to investors free of charge before the conclusion of a contract.
Account Opening
Once the documentation is in place, the Custodian must open accounts on behalf of the fund.
There are two types of accounts which must 'be set up
Security Account
This account is set up to reflect the client's asset holdings.
Cash Accounts
For each security account set up, there will be several cash accounts opened. There will be an
individual cash account for each currency set up i.e., USD, EUR, and JPY etc. The Currency
accounts set up will usually depend on what markets the fund is to trade in or the investment
strategy of that fund. Cash accounts are linked to the securities account. Each time a trade is
initiated for the securities account, cash entries will automatically pass through the relevant
cash account associated with that securities account.
Example
Fund Name:

ABC Company United

Securities Account No.

123456

Cash Account Nos.

USD 555123456
EUR 555123478
GBP 555123490
lPY555123512 etc

Transfer of Securities
Transferring of assets and cash from one custodian to another. This will only take place if the
client has existing portfolios with another custodian and not if it is appointing a custodian for
the first time with a new fund about to be launched. The transfer process involves the
following:
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Agreeing a trade date and a settlement date between the client, the old custodian and
the new custodian to transfer the securities and cash
Instructing the new custodian's agent network to receive in the new holdings, giving
details of the sub-custodian they are coming from, asset name, nominal holding,
name into which they are to be registered and account to be held in.
After transfer date, the new custodian Is responsible for monitoring the receipt of
assets, and the receipt of cash balances thus ensuring a smooth process Is initiated
for the client.
The existing custodian is responsible for settling any transactions which have taken place
prior to the agreed trade date for the transfer. It will also be responsible for the collection of
outstanding. dividends and corporate actions which have taken place before the agreed trade
date.
The existing custodian may also hold back some cash to cover any outstanding expenses to
be paid out of the fund.

15.5 The Cost of Custody

The costs associated with custody are usually made up as follows:
Safekeeping Fees
The fee charged for the safekeeping of assets is normally based on the market value of
securities held in that-particular market. The charge will depend on how developed the
market is. For example, the safekeeping fee for securities held. in the UK will be cheaper
than for those held in an emerging market such as India. The charge is expressed as basis
points (bp) per annum. (1 bp = 0.01%).
Example:

If the value of securities in Custody is USC 100,000,000 and the safekeeping

fee is 1 basis point per annum, the Custody fee will be;
USC 100,000,000 x 0.01% (or 0.0001) = USC. 10,000 per annum
The safekeeping charge may take into account any sub-custodian fees billed to the custodian
or it can be an additional cost passed on to the client, depending on the custodian.
Transaction Charges

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There is a fixed transaction charge per movement of security. Again, the amount charged per
transaction will depend on how developed the market Is. For example, a transaction charge
for a purchase or sale of a UK security will be much less than say, a purchase or sale of a
security in an emerging market such as Pakistan.
Money Movement Charges
Although not all custodians charge for money movements, some do. This can be similar to a
transaction fee and is charged on a per movement basis, the fee dependent on the currency
being moved.
Proxy Voting / Corporate actions
A charge may be made by the sub-custodian to the custodian to cover the announcement of
corporate events. This may sometimes be passed on to the customer by the custodian.
Security Lending Fee
Acting as Lending Agent and managing Security Lending Programme - See Chapter 5
Cash Management Fee
Sweeping, Pooling and Netting - See Chapter 8

15.6 Central Securities Depositories (CSD's)

A Central Securities Depository is a holding place for dematerialised securities which means
there is no passing of physical certificates at settlement. Settlements are recorded by bookentry transfer, on a computerised system, over the participants securities and cash account
on settlement date. CSD's have been set up in several countries for the domestic settlement
of securities, for example, CREST in the UK & Ireland, SICOVAM (Societe
Interprofessionelle pour la Compensation des Valeurs Movilieres) in France, DKV (Deutsche
Kassenverein) in Germany, DTC (Depository Trust Company) in the US. The CSD is
generally owned by a group of participants which is made up of banks, broker-dealers and, in
some cases, institutional investors. Each participant holds an account with the CSD. CSD's
can have links with other CSD's, for example France with Germany for settlement of
securities in other markets.

Example of a CSD: DTC - Depository Trust Company, US

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The Depository Trust Company is a major central , securities depository in the United States
which provides trade processing services for all transactions in the US securities market. It is
owned by broker I dealer and bank participants. The DTC provides a computerised bookentry safekeeping service to its members who can confirm, compare, affirm and settle
purchase and sale transactions with their institutional customers. The following diagram
shows how a transaction flows within the DTC.
From the above workflow, we can see the following:
The broker and investment manager agree trade details after which the broker inputs
the data to the DTC.
The DTC then sends confirmation of the ~de. ~o the investment manager with copies
to the broker and the custodian bank
The investment manager or custodian bank affirm, or acknowledge, that the trade
details agree with their own records. This affirmation is input direct to the DTC.
Once affirmation has taken place, the DTC sends Deliver and Receive instructions to
the custodian bank and the broker
The brokers and the custodian give authorisation to the DTC to settle the trade
International Central Securities Depositories (ICSD's)
ICSD's were set up as international clearing houses for European bonds and other
euromarket instruments. This service is provided by two ICSD's, namely Clearstream and
Euroclear. Clearstream is based in Luxembourg and was set up in 1970 by a number of
financial and banking institutions to serve international markets. It has over 100 shareholders
in 20 countries around the world. It acts as an international clearing house for securities such
as equities and bonds and provides custody services, securities lending and cash clearing in
up to 60 countries.
Euroclear is based in Brussels and was set in 1968 with over 120 shareholder institutions. It
is operated by Morgan Guaranty Trust Company and has over 10,000 participants which
comprise of financial institutions. Like Clearstream, it acts as an international clearing house
for securities such as equities and bonds and provides custody services, securities lending
and cash clearing in up to 60 countries.
Membership and participation to Clearstream and Euroclear is limited to professional
intermediaries, rather than end-investors.

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Clearstream and Euroclear provide a computerised book entry clearance and settlement
service for over 80,000 different securities Including equities, bonds and shares/units in
investment funds.
Clearstream and Euroclear systems have an electronic link with each other called "the
Bridge". The Bridge enables Clearstream customers to settle securities with Euroclear
customers and vice-versa. This is enabled by the electronic exchange of matching and trade
confirmation files between the two systems several times a day.
These two systems have expanded their services to include cross-border clearing, settlement
and custody of many other types of bonds, corporate securities and equities, building links
with overseas markets either through the appointment of sub-custodians or direct
arrangements with National CSO's.
The following diagram shows the settlement process between two Euroclear Participants:
In the above diagram, the following applies:
Brokers agree trade;
Each broker instructs Euroclear of the trade either electronically, by Swift or by Telex;
Euroclear validates the instructions and confirms to brokers that the instructions are
matched or unmatched;
Brokers must rectify unmatched instructions and re-transmit instructions to Euroclear;
Securities are settled the night before settlement date. Trades are settled against payment
by simultaneously debiting the seller's account with the securities and crediting its cash
account with the settlement amount, and vice versa for the buyer;
Settlement reports are transmitted to the participants.
The following diagram shows the settlement process between the Euroclear System and
Clearstream by using the Bridge.
The above diagram provides for the following:
Brokers buy or sell shares, one broker for a Clearstream customer and the other broker for
a Euroclear customer.

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Matching files and trade confirmation files are exchanged between the Clearstream and
the Euroclear system four times a day. The matching criteria includes counterparty,
settlement date, counter value and currency, security code, nominal amount. If there are
discrepancies between two settlement parties, they are notified by way of an unmatched'
report.
Settlement of trades over the bridge between Euroclear and Clearstream customers is
facilitated by two sequential exchanges of delivery files. If delivery is refused by
Euroclear, the entries are reversed and vice-versa.
Settlement reports are available to customers of Clearstream and Euroclear and show the
following:
Securities and Related Cash Movements
Unexecuted Securities Transaction Instruction,

15.7 Driving Forces Impacting on the Custody

Business
There are three forces that have impacted and continue to impact on the custody business.
They are:
1. Market forces;
2. Customer forces;
3. Competitive forces.
Market Forces
Up until the mid-1980's, the custody market was mainly driven by commercial banks who
were the main service providers. The economy was strong and provided healthy asset
growth. Customers were not as interested in quality service or fees as they were in the
overall banking side of the relationship. Nowadays, market forces impacting the custody
business include:
Weak Economy
A weak economy worldwide, which can frequently result in low investment returns, means
that customers are under pressure to seek higher returns on investment. They achieve this by
managing their cash efficiently; entering into securities lending to earn additional revenue
and continuously assessing the performance of their investment managers. Customers are
also seeking to reduce custodians fees and foreign exchange spreads.
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More efficient markets

Restrictions and tax penalties on cross-border investments are continually being reduced by
countries worldwide. Settlement practices need to be standardised and investment needs to
be made in technology to help achieve this.
Future environment
The market is continually changing and will continue to do so. For example, the
implementation of monetary union In 12 countries of the European Union has had the
following effects on the custody market
a) FX revenues have been reduced due to there being only one currency across twelve
countries in Europe;
b) US Investors are more attracted to Europe.
Growth in offshore funds. As companies are becoming more sophisticated in crossborder
investment, there is more awareness of tax effective finance which will result in increased
investment in non-domestic funds.
Customer Forces
In the past, customers had limited power in the market because they were relatively
unsophisticated investors. Customer's requirements in custody were limited and fairly
standard across all market segments.
In the past decade, as customers have become more sophisticated, their demands have
increased. Customers are accessing more and more new markets and entering into new types
of investment. Each customer portfolio has its own set of custody requirements depending on
investment strategy and markets represented in the portfolio. Products that were once
thought of as 'value added' or exceptional, are now expected from the custodian, for
example, Securities Lending, Proxy Services, Customer Access Systems, etc. Custodians will
differentiate themselves based upon their ability to facilitate each customer's unique set of
requirements with solid products, value-added services and quality customer service.
Customers are continually putting pressure on custodians to reduce their pricing on their core
services, thereby reducing profit margins of these custodians. Therefore, as the range of
products the custodians are expected to provide is expanding, their profit margins are
steadily decreasing.

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Criteria for winning new business

As well as having the product requirements, the custodian must also have a set of non service
related criteria in order to win new business in today's competitive market.
These include:
Management commitment
The custodian must be willing to reinvest in the business.
Market leadership
The custodian should be seen as a market leader and have a strong position in customer's
area of business.
Sense of trust
The custodian should seek to form a partnership with Its customer
Customer Access
The custodian should be able to provide the latest technology which is flexible and has
multi-purpose capabilities
Sales and Service Professionals
The custodian should have a knowledgeable and experienced workforce who can take on
a consultative approach with the customer
Fees and pricing
The custodian's fees should be competitive.
Available Technology
The level of technology that the custodian can supply is now a crucial element in the
decision making process.
Customer Service
With so many custodians offering similar services, the level of customer that a custodian
can display will be of paramount importance.
Competitive forces
In the past, custody business was considered to be part of the customer's banking
relationship. There were not many custody providers who invested in technology and
systems therefore there was little competition in the business. As a result, service providers
were in a position to charge high fees and generate high profit margins.
Today, customers are in more control and competitive forces have been impacted by:
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a) Consolidation of domestic and cross-border business; Customers want custodians to

demonstrate a high quality in both domestic and cross-border services.
b) New providers entering the market has led to a large discounting of fees, especially as
some providers seek to gain market share. As a result of this, we have seen a number
of consolidations amongst providers and research indicates that soon there will only be
a small number of major players in the custody market.
15.8 Custody in Ireland
Custody in Ireland had little or no relevance to the financial services industry until the mid
eighties. Due to exchange control limitations, the Fund Managers were Investing mainly in
domestic securities. Custody was provided by the securities departments of the main banks.
Today, exchange control is no longer in place. Since the setting up of the IFSC in 1987,
Ireland has established itself as a leading and highly respected centre for offshore mutual
funds. As a result of this, alongside Irish institutions such as Allied Irish Banks, Bank of
Ireland and Anglo Irish Bank, a number of international institutions have set up in operation,
such as Investors Trust, State Street International, Citibank, etc. Fund managers sometimes
handle their own custody, trustee and fund administration internally. However, a number of
fund managers outsource their requirements to an outside provider. Some providers offer the
whole range of services, often known as "the one-stop shop~ who act as fund administrator,
trustee/custodian or transfer agent on behalf of the fund manager. All custodians try to
enhance existing products or develop new ones to differentiate themselves. Improving cut off
times for instructions & offering Assured income in more and ~ore markets ate just a small
example of how Custodians will try to improve their service delivery.
Custodian
KEY WORDS
Custodian
Trustee
Domestic Custody
Global Custody
Sub-Custodian

RFP
Security Account
Cash Account
Safekeeping
CSD/ICSD

Who uses Custody Services?

Custody is used by various sources such as:
Broker/Dealers, market makers and banks. These are known as market participants and
deal on their own account.

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Institutional Investors such as mutual funds, hedge funds, pension funds, insurance
companies who manage their investments either directly (as a client) or indirectly
(through an investment manager).
Investment managers, also known as Fund Managers or Portfolio Managers, acting on
behalf of Institutional Investors, corporate entities and private client brokers acting on
behalf of high net-worth individuals.
The role of the Custodian
A custodian is appointed to carry out the following functions on behalf of its clients:
Settlement and safekeeping of assets. A fund's assets must be placed with a
custodian/trustee who is responsible for the physical safekeeping and everyday
administration of these assets.
Income. The custodian is responsible for the announcement of income (dividends and
interest) due on assets held, the collection of the income and payment of income to its
customers.
Corporate actions. The custodian is responsible for advising its customers of any actions,
such as rights issues, bonus issues, which are occurring and for the settlement of these
actions where necessary. Rights issues and bonus issues are explained in Chapter 3.
Tax reclamation. The custodian Is responsible for reclaiming excess tax paid on income,
where possible, for customers. 1
Record keeping and Reporting. The custodian is responsible for keeping records of all
assets and cash on behalf of its customer and for reporting this to the customer.
Security Lending. Acting as the Lending Agent for Security Lending Programme covered in more detail in Chapter 5
Value Added Services such as Cash Management (Chapter 8), Cash Projection - Securities
Lending, Class Actions & Proxy Voting.
All of the above will be discussed in more detail In the following chapters.

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Chapter 16 - Custody Services

After studying this Chapter, you should be able to:
Identify the roles of each of the participants in the Settlement of a securities transaction.
Describe the Pre Settlement Functions including trade confirmations, verifying valid
instructions and the methods of trade communication.
Identify why Swift has developed and the different types of Swift messages.
Illustrate the flow of information from when a trade is struck through to settlement.
Differentiate between the settlement functions Delivery versus Payment and Free of
Payment.
Explain the difference between Contractual and Actual Settlement Date.
Define Failed Trades and the Safekeeping of Assets.
Illustrate the different types of Corporate Actions and the role of custodian.

16.1 Settlement
A securities transaction involves a number of parties. Firstly, let us define the roles of each '
participant and how they interact with each other.
Investor
An investor is someone who buys 01"' sells securities with the Intention of making a profit
and thereby increasing the value of their portfolio.
These can be broken down into two broad categories, the institutional investor and the
private Investor.
The Institutional Investor
The largest investor, in terms of net worth, is the Institutional investor, which is an
organisation whose primary purpose is to either invest' its own assets or those managed on
behalf of clients. The fund manager, or investment manager, is responsible for investing
funds in order to get the best return; Institutional Investors are mainly pension funds, banks,
Insurance or investment companies and can be described as "professional" investors.
The Private Investor

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Private- investors, while more numerous,' have smaller portfolio values than the large
institutional investor. These comprise individuals who generally manage their own portfolios
but engage the services of a custodian to settle and hold securities on their behalf.
Broker
The broker acts as an agent or intermediary for the investor. The broker buys or sells shares
on instructions from his/her client (the investor). The broker will buy securities from one
investor and sell to another, charging a commission to both parties.
Custodian
The custodian carries out various functions on behalf of the investor, mainly safekeeping of
assets and associated functions. In this section we will be looking at the custodian's role in
pre-matching and settling trades on behalf of the investor.
Counterparty
A counterparty is merely one party to a transaction. As mentioned above, each transaction
must have both a buyer and a seller. Where an Investor uses a custodian to settle a purchase
on his behalf, the term "counterparty" may also be used to describe the seller's custodian and
vice versa.

16.2 Pre Settlement Functions

Trade Confirmations
Once a securities transaction has been executed, the settlement process begins. Before the
trade can be settled i.e. securities exchanged for cash, certain functions must be completed.
These can be broken down as follows:
Trade details validated between investor and broker
Investor advises his custodian of trade details
Custodian matches trade details with counterparty in the market
The broker, or dealer, having struck a deal with the investor, must formally confirm details of
this trade to the investor. This is traditionally in the form of a contract note. However, with
ever evolving methods of communication, electronic messages are now widely used.
Where the investor uses a custodian to settle trades on his behalf, he must now advise his
custodian of the details of the trade executed. The custodian, in turn, must match these trade
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details with the counterparty in the market. This may be either directly or by using a subcustodian in the local market to act on his behalf. The use of sub-custodians is covered in
more detail in chapter 2.

Verifying Valid Instructions

The custodian has a responsibility to his client to ensure that securities held on behalf of the
client are properly controlled and can only be transferred on receipt. of authorised
instructions from the client. Failure by the custodian to verify instructions, could result in
fraudulent movements of securities over the account, thereby leaving the custodian liable for
any loss suffered by the client. In order to reduce risk, the various different methods of
communicating trade details must be tightly controlled and clear procedures agreed between
parties on the use of each medium. The method of communication to be used is agreed
between both parties at the start of the relationship and may be detailed in the Service Level
Agreement between the custodian and his client.
Communication Methods
Various methods of communication may be used to transmit the trade details to the relevant
parties. The most commonly used are SWIFT, facsimile, E.T.C., proprietary link or hard
copy.
Swift
The Society for Worldwide Interbank Financial Telecommunication (SWIFT) is a key service
provider in the global business of finance, offering a sophisticated solution to the automation
of message exchange through standardisation. All the Society's activities stem from a
fundamental philosophy: To offer the financial services sector a common basis of advanced
technology, a platform of shared solutions and shared cost on which each user can uniquely
build distinctive competitiveness.
The product of an increasing need for communications and processing efficiency, SWIFT
was conceived to provide an advanced telecommunications service to the international
banking community - a vision which was realised in 1977. Over the years the Society has
spread its network coverage and expanded its capabilities to serve the needs of a wider,
diversified user base. The range of transactions processed by the system has broadened, use
of the network has been opened up to non-bank financial institutions, and service extensions

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such as mass data transfer, electronic data interchange, confirmation matching and netting
have been added.
As part of this development, SWIFT has played a pioneering role in applying technology and
international standards to the automation requirements of the financial industry. In the
process it has become an authoritative influence in stimulating dialogue, in the transfer for
knowledge and in the sharing of experience between financial institutions.
The first SWIFT message was sent in 1977 when membership was made up of 513 banks
from 15 countries. Ten years later, in 1987, the securities industry became involved and today
its members include banks, brokers, depositories and stock exchanges. Today, SWIFT is a
closed user group of more than 5,000 financial institutions in over 130 countries - all able to
communicate with each other around the world and around the clock. Over 500 of these
participants are located in Ireland and the UK.
A multi-level combination of physical, logical and procedural security measures ensure
against instructions being changed during processing. All messages are encrypted during
their transit over the SWIFT network. Nobody knows their content - except the sender and
the receiver. Standardised data formats are used to transmit transactions over the network.
This permits total system automation, and eliminates the problem of a huge diversity of
human languages in international business.
Transmissions are effected instantly, with all verifications and authentications carried out
automatically. When sender' and receiver are connected. Simultaneously, the transfer of data'
can take less than 20 seconds.
The system-stores all incoming-and outgoing messages. This provides an accurate audit trait
in addition, a variety of operational reports is generated dally for users to control message
flows.
SWIFT have restructured all Securities Messages (MT500 Series) under the name ISO
15022. Additional. fields and blocks of information are being added to eliminate the use of
narratives and individual code words.
SWIFT message types

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SWIFT messages consist of five blocks of data including three headers, message content, and
a trailer. Message types are crucial to identifying content.
All SWIFT messages include the literal "MT (Message Type). This is followed by a 3-digit
number that denotes the message type, category, and group. Consider the following example,
which is an order to buy or sell via a third party:
MTS02
The first digit (5) represents the category. A category denotes messages that relate to
particular financial instruments or services such as Precious Metals, Syndications, or
Travellers Checks. The category denoted by 5 is Securities Markets.
The second digit (0) represents a group of related parts in a transaction life cycle. The group
indicated by 0 is a Financial Institution Transfer.
The third digit (2) is the type that denotes the specific message. There are several hundred
message types across the categories. The type represented by 2 is a Third Party Transfer.
Each message is assigned unique identifiers. A 4-digit session number is assigned each time
the user logs in. Each message is then assigned a 6-digit sequence number. These are then
combined to form an ISN (Input Sequence Number) from the user's computer to SWIFT or
an OSN (Output Sequence Number) from SWIFT to the user's computer. It is important to
remember that terminology is always from the perspective of SWIFT and not the user.
The Logical Terminal Address (12 character BIC), Day, Session and Sequence numbers
combine to form the MIR (Message Input Reference) and MOR (Message Output
Reference), respectively.
The following is a summary of the message types currently available:
Message Group

Description

Customer Transfers & Cheques

Customer Transfers
Cheque Transactions

Financial Institution Transfers

Financial Institution Transfers

Notice to Receive

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Financial Trading

Foreign Exchange & Foreign Currency Options

Fixed Loans/Deposits
Call/Notice Loan/Deposits
Forward Rate Agreements
Loan/Deposit Interest Payment
Interest Rate Swaps

Collections & Cash Letters

Advice of Payment
Acknowledgement
Tracer
Amendment
Cash Letters

Securities

Orders
Advices/Confirmations of Orders & Trades
Receipt/Deliver Instructions & Securities Lending
Receipt/Delivery Confirmations
Corporate Actions, Advices & Claims
Corporate Events
Statements & Portfolio Management
Special Instructions

Message

Message

Type Description

Type
540

Name
Receive Free

Instructs the Receiver to receive specified securities,

physically or by book-entry, from a specified party

541

542

Receive

without paying an amount of money

Against Instructs the Receiver to receive specified securities,

Payment

physically or by book-entry, from a specified party and

Deliver Free

to remit a specified amount of money in payment.

Instructs the Receiver to deliver specified securities,
physically or by book-entry, to a specified party free of

543

Deliver

payment.
Against Instructs the Receiver to deliver specified securities,

Payment
544

physically or by book-entry, to a specified party against

Confirmation
Receipt Free

545

Confirmation
Receipt
Payment

a specified amount of money.

of Confirms the receipt of specified securities, physically
or by book-entry, from a specified party free of
payment.
of Confirmation of Confirms the receipt of specified

Against securities, physically or by Receipt book-entry, from a

specified party against a specified amount Against
Payment of money.
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548

564

Notice

of Advises of a problem in executing a settlement

Settlement Problem
Notice of Rights

instruction or an attempted delivery

Provides details of a formal notice of rights to a current

Notice of Event

or future debt or equity subscription

Provides particulars of an event affecting a security,
including early notice of rights, a notice of money
income or of income in the form of securities declared

566

but not yet booked.

Advice of Money Advises the Receiver of an event related to cash income
Income

derived from securities held in custody, or being traded

in.

566

Advice

of Provides notice of a forthcoming redemption/maturity,

Redemption
565

or advice of the money amount and details of the

completed redemption.
or Gives voting instructions concerning securities held by

Proxy
Authorisation

535

and the custodian. It may give voting instructions regarding

Instructions to Vote individual proposals.

Statement
of Lists, as at a specified date, the quantity and
Holdings

identification of the securities and, optionally, other

holdings, held by the Sender for the Receiver or the

537

599

Statement

Receivers customer.
of Provides, as at a specified date, details of transactions

Pending

received but not yet elected, for all or selected securities

Transactions

in all or selected safekeeping accounts/sub-accounts, for

Free

Format

all or selected reasons why the transaction is pending.

Free format text used.

Message
Telex
Telex is an electronic method of communication. Messages can be authenticated by the use
of test codes thereby ensuring validation of instructions. Testing and coding messages can be
time-consuming and this method is not widely used by global custodians.
Facsimile

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Instructions may also be sent by facsimile which can be backed up by hard copy for control
purposes. Instructions are authenticated by use of authorised signatories and these must be
checked manually by the recipient against signatory lists on file. For obvious reasons, this is
not a very secure method of communicating securities instructions. When used, a "fax
indemnity" is generally put in place between the custodian and his client to clearly define
liability in the event of fraudulent instructions being received and acted upon.
Electronic Trade Confirmation
An electronic method of communication used between institutions, brokers and custodians,
ETC is now becoming more widely used by brokers in the UK to confirm trade details to
their institutional investors. With the correct software installed, several parties to a trade can
access the relevant information and verify details.
Proprietary Link
Many global custodians offer a direct link to their system via PC to allow clients key in data
from their workstation which is then transmitted electronically by means of file transfer. This
is known as a proprietary link. Reporting can also be made available by the custodian to the
client via this link, which can then be electronically updated on the clients own system.
Hard copy
This is not widely used as a primary source of information, but, as mentioned above, may be
used as back-up to facsimile instructions for control purposes. Many brokers still issue
contract notes in "hard copy" but since large institutional investors require trade details
reported within specific timeframes, these are being gradually overtaken by electronic means
of communication.
The most widely used methods in communicating with global custodians are SWIFT or
proprietary link. This is driven by the need for automation. Information which is
communicated electronically can be automatically uploaded to the custodian's computer
system and routed through to a third party as appropriate i.e. a sub-custodian.

Trade

information which is processed in this manner is referred to as "Straight Through Processing"

(STP) and essentially means no manual intervention is required in order to process the trade
information. Unmatched, failed or completed trades can also be reported back to the investor
using the same method of communication. Trades which have incomplete or incorrect data or
are advised late, cannot be processed automatically and hence require manual intervention to
repair.
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Information Flow: Investor/Fund Manager - Broker - Custodians

The following flow chart illustrates the flow of information from the moment a trade is
struck in the market, right through to settlement.

Trade Flow
FUND
MANAGERRNVESTOR
COUNTER PARTY
(BROKER CUSTODIAN)
1. The Fund Manager or investor places order with broker to buy/sell securities
2. Broker effects deal on the market.
3. Broker issues contract note/trade advice to investor.
4. Investor advises trade details to custodian.
5. Custodian pre-matches trade details with counterparty.
6. Trade is settled between custodian and counterparty.
7. Custodian reports back to investor on status of settled trade.
In an ideal world this flow of information and confirmation would be timely and accurate.
However, many factors can interfere and cause late or failed settlements as a result. These
exceptions will be examined in more detail later.
Pre-Matching
This is a control process whereby the counterparties to each trade compare their instructions
and agree settlement details in advance of anticipated settlement date. Data compared and
verified includes, but is not restricted to, trade date, settlement date, purchase/sale, security
description, nominal amount of securities, currency, price, consideration and counterparty
settlement details.
Why pre-match?
The benefits of pre-matching mean that trade details are compared and any discrepancies
resolved prior to settlement date, thus reducing the possibility of failed trades. It is important
that trades are matched as early as possible in the settlement cycle, thereby ensuring that
maximum time is available to resolve any differences which may arise.

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When is pre-matching mandatory?

In some markets/clearing systems pre-matching is mandatory. This means that trade details
must be submitted to the local clearing house by both counterparties before settlement can
take place. These details are matched, either electronically or manually, and any
discrepancies reported back to each counterparty. Failure to match details within the given
timeframe may result in delayed settlement. Examples such as Euroclear and Clearstream,
depositories which offer specialist clearing house facilities for settlement and safe-keeping of
securities, require mandatory pre-matching between users before settlement can be effected.
Verifying Funds Availability
The settlement of securities trades is linked to the movement of the corresponding cash
countervalue. The Investor must ensure that funds are available to fund any outlay. In turn,
the custodian, having matched the trades with his counterparty, must ensure that he has
sufficient funds available to settle in full. In some markets, overdraft facilities are not
allowed therefore trades can fail if insufficient funds are available. The merits of Contractual
vs. Actual settlement and how each Impacts on funds availability are covered in the
following chapter. Anticipating cash requirements and moving cash is termed "cash
management" and is covered in more detail later in this course.
Projected Outlay
The projected outlay is a net position of all purchases arid sales which are due to settle on a
given day, less any anticipated income from dividends, interest or corporate events. Cash
projection reports can be produced showing balances several days or weeks in advance and
this Information is used to maximise earning potential on anticipated funds.
Positioning Funds
In order to ensure an account is adequately funded, all anticipated cash movements must be
noted. Any shortfall is funded to prevent the account going overdrawn. Any surplus funds are
placed on deposit to ensure credit interest is earned on long balances. If funds are credited to
the account without being noted on positions, a long balance can result on which no interest
is earned. Similarly, if funds are debited to the account which have not been positioned, this
can result in an overdrawn position and debit interest charges.
Settlement Functions

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Trades may be settled in two ways: Delivery Versus Payment (DVP) or Free of Payment
(FOP). DVP is the industry standard term for settling against payment and as such includes
all versus payment transactions.
Delivery versus Payment
Example:
ABC Company Limited buys the following from XYZ Broker
Trade Date:

10 June

Settlement Date

15 June

Nominal:

10,000

Jefferson Smurfit Ordinary 25 cent shares

Price:

1.63

Settlement amount

16,300

True DVP means that securities and cash move simultaneously, i.e. at 12.24pm on 15 th June,
XYZ Broker delivers 10,000 Jefferson Smurfit shares to ABC Company Ltd. and receives
:16,300 at the same time from ABC Company Limited.
In practice, although True DVP is the stated settlement practice, few achieve it. The transfer
of securities takes place at one point in the day while the cash (cheque, credit transfer, etc.) is
cleared at a different point of the day. This is accepted and considered market standard.

True DVP can happen in ICSDs such as Clearstream and Euroclear where banking and
safekeeping functions are linked.
With DVP, one instruction is sent to the custodian giving the trade details as well as the cash
settlement details. The custodian passes this instruction to his sub-custodian.
Free of Payment
A free of payment trade is where the movement of securities Is not linked to a matching
movement of money. Free of payment trades most often occur
Where stock is moving internally across accounts;
Where the customer has changed custodians and moves securities from one custodian to
another but where there is no change of beneficial ownership;
In certain markets, for example Zimbabwe, where the market practice states that trades
cannot settle against the local currency, in this case Zimbabwean dollars, and must settle
against a hard currency such as US Dollars. In this instance, the customer sends two
instructions to the custodian: one to deliver/receive the stock, which would be passed on

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to the Sub-custodian in Zimbabwe; the second to make the payment of monies which
would be passed on to the correspondent in the US. This is often termed a "free and free"
(free trade and free payment).
Where there are New Issues of securities. In this case, the money is paid up front before
the shares are actually issued.
Free of payment trades can cause a certain amount of risk to the fund in so far as the
unitholders may be at a loss if the shares are not received into the fund. In the case of a "free
and free" if shares are delivered out of the fund and no separate payment is received or vice
versa, if money is transferred out of the fund and ne shares are received.
Settlement Accounting
Although all security trades should settle on the pre-agreed settlement date, in reality this
does not always happen. The custodian may offer clients either Actual Settlement Date
Accounting (ASDA) or Contractual Settlement Date Accounting (CSDA), or a mixture of
both, for example CSDA on purchases and ASDA on sales.
Example:

Trade Purchase

Trade Date:

10 August

Settlement Date

Settlement Proceeds:

US$ 1,000,500:

10,000

13 August

The shares were not received from the broker until 15 August.

ASDA is where the custodian will debit the purchase proceeds or credit the sales proceeds of
the trade on the date when the custodian has actually delivered or received the stock. In the
above example, US$ 1,000,500 would not be debited from the customer's account until 15
August. If the above example had been a sale, the proceeds would not be credited until 15
August. The disadvantage from an investor's viewpoint is that, in the case of a sale, non
settlement means that the proceeds are not available. As such, with ASDA successful cash
management is made difficult and the fund's performance could be affected. The
reinvestment of cash from an anticipated sale into other stocks will result in overdraft costs if
the subsequent purchase settles before the outstanding sale.
Additional risk in relation to foreign currency exposure could also arise due to delays in
settlement. If foreign exchange rates move unfavourably during the period between the

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expected value date and the actual settlement date, the settlement process could be - less in
terms of the investor's base currency. Of course, the rates may move in the investor's favour,
but this exchange risk should be avoided if possible.
CSDA is where the custodian will undertake to debit the purchase proceeds or credit the sale
proceeds on the contracted settlement date of the trade, regardless of whether the trade
actually settles or not. In the above example, US$l,000,500 would be debited from the
customer's account on 13 August. The advantages of CSDA are that the custodian guarantees
its customer the availability of the sale proceeds on the contracted date. The custodian takes
the risk of non-settlement on itself. On the other hand, the customer will also be debited
contractually for purchases. If a purchase fails, the custodian will have use of the customer's
funds pending settlement in the market. If a trade fails due to the erroneous or incomplete
instructions from the customer, the custodian will reserve the right to reverse contractually
posted cash entries under advice to the customer.
Failed Trades
A securities transaction which does not settle on the contractual settlement date due to one or
other of the counterparties failing to meet the settlement conditions is considered a failed
trade. The reason' for not' meeting' the' settlement conditions- may be one of the following:

Incorrect amount of stock

Incorrect stock type
Incorrect settlement amount"
Broker has no equivalent trades
Broker Is short of stock
Incorrect broker' named

Failed trades can' prove very costly in certain markets where very high rates of interest can
be charged. Also some markets operate buy-ins. A buy-in related to an action taken by the
buying broker or the local stock exchange to acquire the securities which the selling broker
failed to deliver on time on the open market.

All associated costs are borne by the

counterparty who has failed to deliver and there can also be a penalty or fine imposed on the
failing party.
An example of this can be seen in Thailand where the SET (Stock Exchange of Thailand) has
the authority to force a buy-in on securities not settled on contractual settlement date. Late
delivery of securities by the member brokers is subject to a THB 500 per day penalty and a
varied penalty of between 0.5% and 2.5% of the transaction value, depending on the number
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of late days but no more than THB200,000. Late payments can incur a fine equal to twice the
amount due plus the carrying costs.
The level of costs, penalties on buy-ins varies, according to the market investing in.
In the event of a trade not settling on the settlement date, the sub-custodian is expected to
inform the custodian of the reason for the failure: This information is then passed on to the
client by the custodian. In cases where the sub-custodian has not given the reason for failure,
the custodian is obliged to pursue its agent for immediate explanation.
Once the custodian has been .Informed of the reason for the failure, it will check its own
records to confirm the details and, then refer the' problem to, its-client for investigation and
action. The client will check its records where--appropriate; discuss the problem with its
broker and then confirm new Instructions to the custodian: Once the problem has been
resolved with the client, the custodian re-'instructs the sub-custodian, who will repeat the
trade-matching' procedure with the counterparty
Prompt action by both the sub-custodian' and the custodian will often ensure that failing
trades are corrected. in time for settlement. Efficient sub-custodians,. when possible, will
proactively manage potential failing trades by pre-matching their Instructions with the
delivering or receiving party. This process' identifies discrepancies at the earliest opportunity,
allowing the trade to be corrected before the value date is reached, thereby reducing the
possibility of failure.
Electronic systems help to prevent failed trades. They are faster and more accurate than
manual methods. An efficient global custodian will have experienced staff to back up its
automatic systems when required.
Safekeeping
Depending on the specific market, a trade can be held be the custodian on behalf of the
customer in different ways.
Physical Form
Physical Delivery settlement is the practice of the receipt or delivery of share certificates
which represent the customer's security holding in the marketplace. These are held, usually in

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a vault, by the sub-custodians on behalf of the customer. Ownership can be registered or

bearer.
Registered Ownership
The beneficial owner's (or its appointed nominee's) name and address are detailed on the
certificate. These details are also held on the company Register.
Bearer Ownership
No name is printed on the certificate therefore the holder, or bearer, is the legal owner of the
certificate. For this reason, bearer certificates require a high level of security over their
safekeeping.
Book Entry
Where holdings are held in electronic book-entry form, usually by a central depository on
behalf of the custodian, e.g. Clearstream or EurocJear. There are no paper certificates.
How securities are held
The custodian can hold securities on behalf of the customer in two ways

Omnibus Account
This is a pooled safekeeping account. Under an omnibus account, the beneficial owner of the
stock is not designated on the certificate, or any other record at the registrar or securities
depository. The name on the certificate will be that of a pooled nominee company which will
normally be some variation of the custodian's name. The omnibus accounts offer greater
flexibility whereby settlement of sales is made out of the custodian's pool of customers
holdings. Under this arrangement, the custodian has a pool of stock which represents the
holding of a number of clients. The custodian must be able to designate individual client
ownership within its own computer records to enable it to determine whether the client holds
sufficient stock to be sold.
Segregated Account
There is one account per customer, fund or fund segment. The beneficial ownership is clearly
identified and noted on the company's register. A number of markets dictate that each fund
must hold a unique account and cannot be held in omnibus form.
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Registration
Upon settlement of a trade purchase, the custodian is responsible for re-registering that
security from the seller's account name into the omnibus account name or the segregated
account name. Registration time frames differ from market to market, but in, some cases, this
can take up to 6 weeks, particularly in the emerging markets. Even when settlement takes
place on time, delays in registration of purchased stock may be experienced leading to
problems in the customer's ability to subsequently sell and deliver the security on time. It is
important that the custodian lets Its customers know what the registration timeframes are so
that they can efficiently manage their portfolio and reduce any interest claims which could
arise from not being able to deliver the security due to delays In re-registration.
In certain markets, where the re-registration period takes a long time, holdings can be held in
Street Name. When this happens, the beneficial owner of the security is not registered on the
certificate and the holding can be sold-on without having to wait for re-registration period.
Investors will sometimes ask their custodian to hold the security in street name if they know
they will be selling that security soon after purchasing it. Custodians/Trustees will usually
request all securities to be 'registered', as holdings in street name will not guarantee certain
services to customers, i.e. dividend collection. This could be a potential loss to the underlying
unitholder.

Chapter 17 - Fund Documentation

After studying this Chapter, you should be able to:
Define the contents of the constitutive documents of a Fund.
Identify the documentation required for an Investment Company, Unit Trust and Common
Contractual Fund.
Examine the document to which a trustee is party to, or must submit, as part of the
Financial Regulator fund approval process.
Identify the factors, which the Trustee must take into account when reviewing fund
documentation and the factors to be considered by the Trustee as to whether it can
discharge its duties.
Examine the settlement & custody risks associated with investment in Russia and the
Financial Regulator minimum standards with respect to custody of equity securities in
Russia.

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17.1 Fund Documentation

Prospectus
This prospectus, a copy of which must be provided to all potential investors, must provide
the following information to potential investors as detailed within the Financial Regulator
Notices, UCITS 6 and non-UCITS 9.

Detailed description of the funds investment objectives, policies and restrictions.

Procedures for the subscription and redemption of shares or units.
The method of calculation of the net asset value of the fund.
Names and descriptions of the board members of the investment company or the

Management Company and information on each of the service providers.

Details of the fund policies on distributions, borrowing powers and efficient portfolio
management policies.
UCITS III funds also require a simplified prospectus to be submitted to the Financial
Regulator for approval.
The extent to which the proposed UCITS will invest in Russia should be clear in the
prospectus.
Regulation 74 of the European Communities (UCITS) Regulations 2003, as amended,
requires inter alia that a UCITS III must publish a simplified prospectus and a Risk
Management Process. Guidance papers are available from the Regulator in relation to these
two documents.
Memorandum and Articles of Association
If an Investment Company is being established it must be constituted by a Memorandum and
Articles of Association and a Unit Trust is constituted by a Trust Deed, which is signed by
the trustee and the manager of a scheme. If an Investment Limited Partnership is being
established this constituted by a Partnership Agreement and if a Common Contractual Fund
is being established it is constituted by a Deed of Constitution signed by the Manager of the
Fund and the Custodian.
There documents set out the various rules of the scheme and specific information must be
contained in the documents.
The Companies Act, 1963, provides that the following clauses must be contained in the
Memorandum of Association:

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The name clause

The objects clause
The limited liability clause
The capital clause
The association clause

The Articles of Association set out the rules for the management of a companys affairs. The
Articles of Association may be altered or added to by means of a special resolution subject to
the provisions of the Companies Acts and to the conditions contained in the memorandum of
association. Any alteration or addition so made is valid as if it had been contained in the
original articles and is subject to alteration in the same way.
The Trust Deed
The Trust Deed sets out the various rules of the scheme and the equivalent document for an
investment company is the Memorandum and Articles of Association. The Trust Deed
regulates the relationship between the trustees, the manager and the unitholders and sets out
their respective rights and obligations.

Although the unitholders will not individually sign the Trust Deed, by purchasing units in the
fund they will automatically become bound by the terms of the Trust Deed even though they
may not have seen a copy of the document. The main terms of the Deed will be summarised
in the prospectus and copies of the Deed are available on request.

Certain minimum

obligations must be undertaken by the trustees and the manager and for a UCITS unit trust
there are detailed in the UCITS regulations and for non-UCITS unit trust these are specified
in the Unit Trusts Act.
As the Trust Deed incorporates provisions relating to safekeeping and other custodial
services a separate Custody Agreement is not required. The Trust Deed also contains the
obligations of the Manager of a trust so a separate management agreement is not required for
a unit trust.
The Deed of Constitution
The Deed of Constitution sets out the various rules of the scheme and the equivalent
document for an investment company/Unit Trust if the Memorandum and Articles of
Association/Trust Deed. The Deed of Constitution regulates the relationship between the
custodian, the manager and the unitholders and sets out their respective rights and
obligations. The deed also sets out the various rules of the scheme .

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Management Agreement
This is only if the fund is an investment company, which purposes to use an IFSC licensed
management company. The use of an IFSC licensed management company is not obligatory.
This will not be required where the fund is a unit trust, as the relevant provisions form part of
the trust feed.
Investment Management Agreement
The Investment manager is responsible for the fund investments in accordance with the fund
prospectus. This Agreement sets out the role and responsibility of the investment manager.
It is agreed and signed between the Investment Manager and Manager of a Unit Trust or an
Investment Company. The following clauses are detailed:

Appointment and Authority of the Investment Manager

Investment Management Services
Remuneration of the Investment Manager
Liability of the Investment Manager
Conflicts of Interest

Administration Agreement
This agreement details this services to be provided by the Fund Administrator which
generally include all fund administration, record keeping, accounting services i.e. the
production of the NAV in accordance with the valuation methodology detailed in the fund
prospectus, production and delivery of unaudited and audited financial statements for a
scheme. Filing of Financial Regulator returns in accordance with UCITS 7 and non-UCITS
10.
In addition, the Administrator can be appointed service provider for maintaining the
shareholder or unitholder register and related transfer agency and shareholder services.
Such services are detailed within the Administration Agreement.

In the event the

Administrator is not appointed to fulfil such services, a Transfer Agent is appointed. In this
regard, a Transfer Agency Agreement is executed between the service provider and
manager or Investment Company.
Custodian Agreement
If an Investment Company, Common Contractual Fund or an Investment Limited Partnership
is established it must appoint a custodian pursuant to a custodian agreement. This will not be

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required where the fund is a Unit Trust as the relevant provisions will form part of the trust
deed. The key provisions of a custodian agreement are:

A list of all circumstances in which the custodian is permitted to transfer away the assets
of the fund.

The circumstances when the custodian is allowed to pay out cash belonging to the fund.
A list of circumstances (if any) where the custodian is entitled to act without receiving
instructions from the fund.
A list of procedural requirements to ensure the authenticity of instructions to the custodian
(usually referred to as Proper Instructions) on which the custodian is able to act.
The amount of fees payable to the custodian and the provisions for the payment of the
custodians expenses by the fund.

The circumstances in which the custodian will be liable for losses suffered by the
fund in the event of loss or damage to the assets in the custody of the custodian.
Provision for the appointment of sub-custodians.
Details of the circumstances when the agreement can be terminated.
How to deal with conflicts between the custodians own interests and the interest of the
fund and its investors.
Sub Custodian/Prime Broker Agreement
It is important to note that a custodian may appoint one or more sub-custodians to settle and
safe keep the fund assets. This would apply in the event that the trustee/custodian does not
have a global presence to settle and safe-keep the funds assets, as it may be established as an
independent company in Ireland or is a subsidiary of a parent company. In this instance the
trustee/custodian often appoints a sub-custodian that has a global presence to settle and safe
keep assets. It may be subsidiary within the trustees/custodians group of a third party and
is not required to be located and have a registered address in Ireland. If this applies a global
sub-custodian agreement is put in place between the two parties. We will look at the
practical fulfilment of this role within Chapter 4 of this manual.
A Prime Broker Agreement is used for hedge funds.

Hedge Funds can be set up as

professional collective investment schemes which are marketed solely to professional

investors and authorised by the Authority under the provisions of NU 12, (PIF), and
schemes marketing solely to qualifying investors and authorised by the Authority under the
provision of NU 24, (QIF) of the NU Series of Notices. A hedge fund may enter into a
relationship with prime brokers to provide some of the following services: clearing and
custody facilities; intraday credit to facilitate foreign exchange payments and securities

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transactions; margin credit to finance purchases of equity securities; and securities leading to
support a schemes short positions. See Appendix 1 for Guidance Note /04 Professional
collective investment schemes-Appointment of prime brokers and related issues for further
information on hedge funds and the appointment of prime brokers. Where a prime broker to
be appointed by a fund and the prime broker is holding assets of the fund, the
Trustee/Custodian is required to appoint the prime broker as a sub-custodian.
Conflict between the Prospectus and Fund Constitutional Documentation
The Prospectus contains a summary of the Trust Deed, Memorandum & Articles of
Association in Deed of Constitution (Constitutional Documentation).

In the event of

conflict between the provisions of the Prospectus and Constitutional Documentation, the
provision of the Constitutional Documentation will prevail.

As the fund lawyers are

responsible for drafting fund Constitutional Documentation and the Prospectus, the instances
of conflict are few. However, as most investors ready only the Prospectus in the event of any
conflict the manager, board of directors of an investment company, general partner of an
investment limited partnership (as the case may be) and trustee/custodian must also carefully
consider whether in adhering to the provisions of the Constitutional Documentation a
unitholder/shareholder is being prejudiced. Examples here would include the distribution
provisions, which could result in differences in the method by which the amount available
for distribution is calculated. If in the event of a conflict, the board of directors of an
investment company, general partner of an investment limited partnership (as the case may
be) decide that they wish to follow the terms of the Prospectus then the Constitutional
Documentation will need to be amended.

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Chapter 18 - Traditional Trading Strategies & Alternative Investment Specific

Regulation for Irish Domiciled Funds
After studying this Chapter, you should be able to:
Differentiate between different asset classes commonly used by UCITS and non-UCITS
collective investment schemes, and the type of regulated funds product available.
Define commonly used investment strategies pursued by managers of collective
investment schemes.
Describe the Irish Regulator environment for alternative investment strategies.

18.1 Commonly available Fund Products and Asset Classes

In accordance with both the UCITS and non-UCITS Notices issued by the Financial
Regulator, Irish regulated Collective Investment Schemes are required to disclose clearly
their investment objectives and policies. The description must be comprehensive and
accurate, readily comprehensible to investors and sufficient to enable investors make an
informed judgement on the investment proposed to them. Very often, collective investment
schemes aim to achieve their objectives by focusing on particular assets classes and
strategies. Commonly used classifications are employed to describe the products available by
referencing the target assets of the scheme e.g. money market funds, global equity funds,
leveraged futures and options schemes or funds of funds. The categorisation of these fund
products are generally self explanatory, and the following is a brief description of the more
widely available products and their objectives.
Equity Funds
As the name suggests, Equity Funds focus their investments on equities listed on
regulated exchanges. Equity Funds are normally constructed on a geographical and/or
sectoral basis. They may also be constructed such that their target investments are decided on
the basis of market capitalisation. Examples might include a US Small Cap Equity Fund, that
will focus investments on listed U.S. equities with market capitalisation of less than US$2bn,
or a Pacific Equity Fund that will focus investments on equities listed on regulated
exchanges in the Far East.
Generally speaking, asset managers of a "long only" equity fund will attempt to outperform
the relevant market by stock selection, i.e. focusing on investments it thinks will rise in value
in the future. Global Equity Funds have a very broad remit, allowing the asset manager to

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make decisions not only on the basis of sectors and market cap, but also to select those
markets it believes will outperform.
Bond Funds
Bond funds are broadly defined as funds that invest in fixed and floating interest securities
issued by governments and corporations that provide regular fixed and floating interest
payments. Bond funds can be structured in many different ways with differing emphasis on
risk and return.
Like Equity Funds, Bond Funds may be structured on the basis of geographical or sectoral
focus. The risk adverse investor for example may be more suited to a US Govt Bond Fund. A
riskier type of investment might include a high yield corporate bond fund or junk bond fund,
focusing on fixed interest securities issued by fledgling or small firms with lower credit
ratings. Other differentiating factors include time to maturity of underlying investments or
taxation on interest payments such as municipal bond funds.
Money
Money Market Funds - invest primarily in near money, short-term (under one year)
government treasury bills, corporate notes which pay a fixed-rate of interest, certificates of
deposit and commercial paper. The rate of return for money market funds tends to be lower
than for funds that are managed for long-term return, but they are very low-risk investments.
Money market funds can be established as both a UCITS and non-UCITS. A distinct
characteristic of money market funds is the stable NAV money market fund. Any gains or
income in excess of the stable NAV are either distributed to shareholders in the form of cash
or additional shares in the fund. Not all money market funds use the stable NAV model
however.
Irish money market funds are generally valued using amortised cost and, are subject to
Guidance Note 1/08 of the Financial Regulator.
Index Tracking Funds
Index tracking funds exploded in popularity in the 1990s when a handful of firms began
offering these products, which have been used by professional money managers for decades,
to small investors.

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Their success is based on the idea that they get round the perceived drawback of traditional
actively managed funds. Traditional fund managers buy shares in companies that they hope
will beat the relevant index, such as the FTSE 100 or the All-Share. In other words, they aim
to achieve returns better than the wider stock market. However, in doing so, the majority
pick the wrong stocks and their fund then underperforms the market.
Trackers do something very different. They attempt to track the performance of the index
itself, rather than set out to beat it. This is because they believe that in the end, no traditional
manager outperforms the index for very long, and if that is so, it makes more sense to track
the index. How they do this differs between funds. Some trackers buy shares in "II the
companies that make up the index. Others use complex financial instruments to track what
the index does by buying shares in a cross-section of companies. This is why the
performance of, say, a UK FTSE tracker funds can differ slightly between providers.
The main benefit of Index Tracker Funds is the cost. Since tracker firms do not need to have
expensive teams of experts who need to follow what individual companies are doing, they
tend to be cheaper to run.
Exchange Traded funds (ETF)
Exchange traded funds behave similarly to equities. They tend to be closed-ended, in that it
is not possible to subscribe or redeem holdings in the usual manner, but are openly tradable
on recognised exchanges. A common example of the ETF are Real Estate Investment Trusts
or REITs.
Shariah Funds
Shariah Funds are Islamic ethical investment vehicles. The main business of the target
investments must not be in violation of Shariah Law, therefore, it is not permissible to
acquire the shares of the companies providing financial services on interest, like
conventional banks, insurance companies, or the companies involved in some other business
not approved by the Shariah, such as the companys manufacturing, selling or offering
liquors, pork, haram meat, or involved in gambling, night club activities etc.

If the main business of the companies is halal, like automobiles, textile, etc. but they deposit
their surplus amounts in an interest-bearing account or borrow money on interest, the share
holder must express his disapproval against such dealings, preferably by raising his voice
against such activities in the annual general meeting of the company.

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If some income from interest-bearing accounts is included in the income of the company, the
proportion of such income in the dividend paid to the share-holder must be "purified" as
directed by the Advisory Board, which is appointed by the fund to provide advice in respect
of compliance with Shariah Law, for example, by giving such proportion to a suitable
charity, and must not be retained by him. For example, if 6% of the whole income of a
company has come out of interest-bearing deposits, 6% of the dividend must be given in
charity.
Private Equity Funds
Private Equity is an asset class asset consisting of equity securities in operating companies
that are not publicly on a stock exchange. Typically private equity funds will make
investments in less mature companies, for the launch, early development, or expansion of a
business, or in more mature companies that are looking for capital to expand or restructure
operations, enter new markets or finance a major acquisition without a change of control of
the business. Private Equity Funds can also take the form of infrastructure funds investing in
public works such as bridges, road, tunnels airports etc. or in energy and power such as
companies engaged in the production and sale of energy.
Given the nature of the investment, private equity funds are high risk investments,
particularly so in the case of venture capital where a fund purchases start up companies. On
the other hand returns can be very high, with the best private equity managers considerably
outperforming the public markets. Private Equity Funds cannot be established as UCITS.
Property Funds
As the name suggests Property Funds are collective investment schemes that invest in
property or property related assets, such as REITS, unit linked policies or companies whose
main activity is investing in, dealing in, developing or redeveloping property. Like private
equity funds, property funds by the nature of the investment are highly illiquid vehicles that
cannot be established as UCITS. Valuations are also subjective, and generally a property
valuation specialist will be appointed to value the assets.
LDIs are most prominent in the funding schemes of defined-benefit pension plans, which are
designed to provide a predetermined pension upon retirement. The liabilities in these funds
arise as a result of the "guaranteed" pensions they are supposed to provide to members upon
retirement.
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Liability Driven Investments

Liability driven investment is a form of investing the main goal of which is to manage its
assets in order to meet all liabilities when they are due, both current and future. This form of
investment is most common in defined benefit pension plans, whose liabilities can reach into
the billions of Euro for the biggest plans, and which are designed to provide a predetermined
pension upon retirement.
Pension funds determine future liabilities by estimating how long beneficiaries are going to
live. That estimate is made by actuaries using past longevity data. Fast changing lifestyle and
work practices combined with vastly increased knowledge of health and the aging process
mean historical longevity tables are probably of limited use for estimating future longevity.
Pension liabilities are worse than they appear, due to the rapid and likely quantum leap in life
expectancy.
Multi-Manager Funds
A Multi-Manager fund aims to avail of the best expertise and best performing fund managers
in the market. There are two types of Multi-manager Funds:
Fund of Funds - This fund has one manager who looks to invest in a portfolio of funds
offered by other fund managers, always trying to add/delete funds that he expects to over
or underperform the market
Manager of Managers - This is where a manager will allocate money directly to fund
managers (not therefore investing in funds themselves) to invest into the market.
From an investors perspective the primary downside of multi-manager funds is their cost.
Management and administration costs must be paid for the top level manager and for each
manager selected.
Master-Feeder Funds
Master-Feeder Funds are funds that are established, the" Feeder, to invest substantially all of
its assets in another fund, the Master. Master feeder arrangements reflect the decision of the
investment manager to accumulate all funds into one central pot - the master fund - to
enhance the critical mass of tradable assets or reduce the amount of transactions.

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Master-Feeder Funds may also be established to sell as tax efficient vehicles for investors.
For example the Master may be established in a different domicile to the Feeder, with the
investor in a third domicile. The intention is to create a tax advantage for the investor by
investing through the feeder rather than investing in the master directly which, by virtue of
domicile of the investor, may be a more tax punitive arrangement.

18.2 Alternative Investment Strategies

One category of fund not mentioned earlier is the Hedge Fund or Alternative Investment
Strategy. The term "Hedge Fund" is probably in fact a misnomer as it is very often the case
that hedge fund managers do not take measures to hedge risk arising from underlying
investments. Rather, hedge fund management involves aggressive trading strategies that are
unhindered by regulatory investment limits. There are numerous strategies that can be
employed but typically alternative investment managers avail of a broad use of short selling,
swaps, derivatives trading and leverage to achieve their objectives.
Hedge fund returns can far exceed those of traditional mutual funds, and they allow
managers to perform in times of falling as well as rising markets. As with private equity
funds however the risks tend to be considerably higher.
In most markets, hedge fund investments are limited to qualified individuals with minimum
levels of wealth and institutions. Typically a performance fee of 20% of performance is
charged by managers, in addition to a standard management fee charge. Administration of
these vehicles also tends to be more expensive than for traditional funds, primarily because
of pricing complexity and performance fee calculation methodologies. The following gives
an indication of some of the investment strategies employed by hedge fund managers
Long Short Equity
The long short equity strategy involves buying equity which is expected to rise in value and
selling equity that is expected to fall in value. Short selling involves borrowing and selling a
stock in the expectation that the price will fall, and buying it back at a lower price in the
future to cover the borrowed stock position. The prime broker appointed by the manager
provides the stock to be sold and receives a fee.

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Managers can take a fundamental approach on the basis of a bottom up analysis of the
fundamentals of target companies, or take a quantitative approach based on complex
programs developed by the manager.
There are an infinite number of strategies that can be employed in long short equity but
generally the focus can be global, regional or sectoral. Managers may also target growth
companies or large cap. They may take a long term view on investment or be frequent
traders. Some may also try to hedge out general market risk through the use of derivatives.
Risk of loss in the long short strategy is generally accepted to be high.
Long Biased, Aggressive Growth
Not unlike the private equity fund, this strategy will focus on equities that are expected to
experience significant growth in earnings per share. The strategy often targets small cap
stocks and managers are very often sector specialists. Hedging is often undertaken by short
those stocks in the sector which are expected to underperform or by investing in index
derivatives to remove the effects of market shock. Short Biased strategies employ the
opposite logic to long bias.
Event Driven Opportunistic Strategies
Event Driven strategy normally involves 2 distinct principal strategies - merger arbitrage and
distressed. Merger Arbitrage involves analyzing potential mergers and taking a view on
whether they will succeed. The stock of a company acquiring will normally go down on the
announcement of a potential merger and the stock of the company being acquired goes up.
This difference expands as one get closer to the deal date. If the deal does not proceed, the
prices revert. If the manager believes the deal will proceed, it will short the stock of the
acquiring company and go long the company being acquired. They take the opposite
approach if they believe the deal will not proceed.
In the case of distressed strategies, the managers will most often buy debt of companies in
trouble at a large discount, based on their analysis of whether the company will survive and
repay the debt or the value of the assets securing the debt. The funds can purchase debt
instruments or participations in loans. Other opportunistic strategies may include for
example investment in IPOs and taking position on stocks in anticipation of earnings
announcements

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Global Macro
This is the strategy followed by some of the most famous hedge fund managers such as
George Soros. The strategy involves taking a global or regional position on interest rates,
currencies .or markets with an aim to profit from. changes in global economies. The strategy
can involve a wide variety of instruments, degrees of leverage as well as both qualitative and
quantitative analysis. Leverage and derivatives are used to accentuate the impact of market
moves.
Long Only (Concentrated)
This is a relative new addition to the hedge fund family and most often involves taking a
very fundamental approach to investing. The funds will invest in a small number of stocks
(which would often be prohibited in regulated funds). They will build up positions to
influence the direction of the company (either with or without management support) to
unlock shareholder value which is not reflected in the share price.
Convertible Arbitrage
This strategy involves exploiting the difference between the price of a convertible bond and
the equity upon which the bond is based. The manager will be long the bond and short the
equity or the opposite way depending on what effect the ultimate conversion will have on the
equity price.
Equity Market Neutral
The manager will try and remain neutral to market performance by using off-setting long and
short positions. The aim is to achieve performance ' based on stock selection only (pure
alpha). For instance the manager may be long and short stocks in the same industry selecting
both based on the fundamentals of each stock. Given that the manager is long and short by
an equal degree in the sector, any shocks to the sector will not adversely affect the
performance of the Fund. From an operational perspective it is very similar to long/short
equity.
130/30 Funds
Traditionally, pension funds have been reluctant to pursue absolute return or hedge fund
strategies because of inherent risk. Similarly, retail investors have been unable to invest in
hedge fund strategies because of regulatory restriction.

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The 130/30 Fund is a relatively new hedge fund strategy, designed to encourage risk averse
institutional investors and retail investors to engage in alternative investments. The concept
is simple. The fund will invest 100% of NAV in long securities. It will borrow and sell short
to the value of 30% of NAV and use the proceeds to invest in a further 30% long. The net
result therefore is 130% long and 30% short. Theoretically the fund is market neutral and the
enticement to, for example pension funds, use of alternative strategy is limited to 30% of
NAV and therefore less risky than an absolute return fund. From a regulatory perspective
UCITS funds are not permitted to short securities. The 130/30 objective is achieved therefore
through the use of derivatives in UCITS Funds.
The advantages of the strategy according to 130/30 managers is that where a long only
manager follows an index and he takes a negative view on a security, his negative bias is
limited to not investing in that security. With a 130/30 fund the manager can extend his
negative bias to short positions and use the proceeds to extend positive bias on long
positions, The result therefore is to release more alpha from the investments while remaining
market neutral.
There is insufficient track record in these strategies to determine if they will succeed. What is
clear however that to date the limited number of managers is have underperformed their
benchmarks and fees generally tend to be higher than traditional long only funds.
Multi Strategy Fund of Hedge Funds
As the name suggests a multi strategy fund of hedge funds will try to identify the best hedge
fund managers based on past performance, across a range of strategies highlighted above.

18.3 Alternative Investment Strategies : Regulation in Ireland

As noted in Section 6.2, hedge funds and alternative investment fund strategies are not
available to retail investors under the Irish regulatory framework. The non-UCITS Notices
however provide for the establishment of Irish regulated hedge funds under two vehicle
types, the Professional Investor Fund (PIF) and the Qualifying Investor Fund (QIF)
Non-UCITS Notices. Professional Investor Funds and Qualified Investor Funds
Hedge funds in Ireland can be established as a PIF or a QIF. Regulation outlining structure
and investment parameters are set out in the non-UCITS Notices sections NU12, Schemes
Marketing Solely to Professional Investors and NU24, Schemes which market solely to

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Qualifying Investors and which are not bound by the limits relating to Investment Objectives
and Policies set out in these Notices.
NU 12: Professional Investor Funds (PIFs)
The most salient characteristics of PIFs, as set out in the Non-UCITS Notice 12, are as
follows:
a) For a fund to qualify as a PIF it must have a minimum subscription requirement of
125,000 or its equivalent in other currencies. The aggregate of an investor's investments in
the sub-funds of an umbrella fund can be taken into account for the purposes of determining
this requirement.
b) Exemptions to the minimum subscription requirement can be granted to directors and
employees of the management company or the fund and the investment manager of the fund.
In the case of employees, the employee must be directly involved in the investment activities
of the fund or is a senior employee and has experience in the provision of investment
management services.
c) The conditions and restrictions set out in the Financial Regulator's non-UCITS Notices, in
particular those related to investment and borrowing, may be disapplied in the case of PIFs.
Notices may be disapplied in whole or in part on a case by case basis.
In order for the PIF to disapply the general investment restrictions it must apply for a
derogation from the Regulator in its letter of application for authorisation of the PIF.
d) The prospectus must indicate, in a prominent position, that it has been authorised by the
Financial Regulator to market solely to professional investors. It must describe the
investment objectives of the fund and this description must be comprehensive and accurate,
readily comprehensible to investors and be sufficient to enable investors make an informed
judgement on the investment proposed to them. The Prospectus will also contain quantitative
parameters which limit the extent of leverage employed by the Fund.
NU 24: Qualifying Investor Fund
The most salient characteristics of QIFs, as set out in the non-UCITS Notice 24, are as
follows:
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a) The conditions and restrictions related to investment objectives and policies and leverage
set out in the Financial Regulator's Notices are disapplied in full in respect of funds
marketing solely to qualifying investors.
b) Investment companies marketing solely to qualifying investors must confirm in writing to
the Financial Regulator that the fund will maintain the aim of spreading investment risk as
required under section 263 2(a) of the Companies Act, 1990 Part XIII.
c) A QIF must have a minimum subscription of at least EUR250,000. The aggregate of an
investors' investments in sub-funds of an umbrella can be taken into account in for the
purposes of determining this requirement.
d) A Qualifying Investor is defined as any natural person with a minimum net worth
(which excludes main residence and household goods) in excess of EUR1,250,000.
Or
Any institution which owns or invests on a discretionary basis at least EUR25,000,000 or its
equivalent in other currencies, or the beneficial owners of which are qualifying investors in
their own right
e) Like PIFs an exemption from the minimum subscription and qualifying investor criteria is
granted to directors and employees of the management company or the fund and the
investment manager of the fund. In the case of employees, the employee must be directly
involved in the investment activities of the fund or is a senior employee and has experience
in the provision of investment management services.
f) Qualifying Investors must certify in writing that they meet the minimum criteria outlined
above and that they are aware of the risk involved in the proposed investment and the fact
that inherent in such investments is the potential to lose the entire sum invested.
g) The Prospectus must indicate in a prominent position that the fund has been
authorised by the Financial Regulator for marketing solely to qualifying investors. It must
specify the minimum subscription requirements and add the following:
"Accordingly, while this fund is authorised by the Financial Regulator, the Financial
Regulator has not set any limits or other restrictions on the investment objectives, the
investment policies or on the degree of leverage which may be employed by the fund"
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In the case of investment companies the following sentence must be added to the above:
The fund must comply with the aim of spreading investment risk in accordance with
Section 263(2) (a) of the Companies Act 1990 Part XIII"
h) The Prospectus must describe the investment objectives and investment and borrowing
policies of the fund and this description must be comprehensive and accurate, readily
comprehensible to investors and be sufficient to enable investors make an informed
judgement on the investment proposed to them. The Prospectus will also contain quantitative
parameters which limit the extent of leverage employed by the fund.
i) The periodic reports issued by a QIF must, where relevant, disclose if distributions have
been made out of the capital of the fund.
Appendix I to non-UCITS Notice 24 sets out the Notices from which a QIF receives an
automatic derogation. It also highlights the Notices that a QIF must adhere to. The notices
include restrictions on dealings by related parties to the QIF; information and documents
required by the Regulator in support of a fund application; Trustees eligibility III criteria and
duties and conditions applicable to trustees and information to be included in monthly
returns.
The full details of a QIF's automatic derogations are set out in Appendix 4.
Appointment of Prime Brokers: Irish Regulation
Under Irish regulation a non-UCITS retail fund is not permitted to sell assets that they do not
own. To establish a fund as an Irish regulated hedge fund with the ability to short securities,
the fund must be set up as either a PIF or a QIF, both of which can obtain a derogation from
this particular investment restriction.
The nature of the investments of hedge funds is such that they must have the ability to
borrow securities and cash to be able to sell short, invest on a leveraged basis and
achieve an absolute return. Prime brokers are established primarily to provide such
lending and clearing facilities. In return the Hedge Fund must deposit collateral with the
prime broker. The collateral deposited takes the form of the long securities and credit cash
balances held by the hedge fund. The Prime Broker benefits by earning fees on financing the
client's long and short cash and security positions, and by charging, in some cases, fees for
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clearing and/or other services. The prime broker also acts as global custodian for the fund,
settling its security and cash transactions and safeguarding the assets of the fund
Under Irish regulation, the Irish trustee is required to appoint the prime broker as its
global sub-custodian. Like a fund that invests in long only securities, the prime broker as the
appointed global custodian appointed by the trustee must hold assets on a fiduciary basis in
segregation from its own proprietary assets. Where the prime broker has lent securities to the
fund, it is permitted under Irish regulation to take title to fund assets and use those assets for
its own purposes. This practice is known as usage or rehypothecation. Restrictions regarding
the appointment of prime brokers and limits on the amount of rehypothecation of assets are
detailed in the Financial Regulator's Draft Guidance Note /04, Professional Collective
Investment Schemes-Appointment of Prime Brokers and Related Issues. The Draft Guidance
Note is included in Appendix 1.
While the Guidance Note is still in draft form, the regulator expects that Irish domiciled
hedge funds, their managers and trustees adhere to its requirements. As part of the fund
authorisation process the Irish trustee is required to confirm in writing that it can discharge
its duties as set out in this draft guidance note. Without such a confirmation, the Regulator
will not authorise the fund.
Draft Guidance Note /04 : Appointment of the Prime Broker (PB) and Rehypothecation of
Assets
The following are the more important restrictions to consider in relation to the
appointment of prime brokers or where transactions are carried out with an OTC
counterparty :
A PIF or QIF may enter into relationships with prime brokers where the fund can meet with
the following requirements (extracts from the Guidance Note in italics):
2"(a) A PIF and a QIF may pass assets of the scheme to a prime broker ("PB")
which assets the PB may pledge, lend, rehypothecate or otherwise utilise for its
own purposes under the following conditions:
(i) In the case of a PIF, the assets so passed shall not exceed 140% of the level
of the PIF's indebtedness to the PB. For the purposes of this limitation, "assets
so passed" will include cash on deposit with the PB"
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"Indebtedness" is taken to mean the total value of assets owed by the fund to the prime
broker, including debit balances and the value of securities borrowed and any other cash
owed to the PB under derivatives contracts.
"In the case of a QIF there is no limit on the extent to which assets may be passed to the
PB, but the extent to which assets are available to the PB must be fully disclosed in the
prospectus issued by the QIF. "
"(ii) The arrangement incorporates a procedure to mark positions to market daily, in
order to meet the above requirements on an ongoing basis. "
This means that the fund must have a mechanism in place to ensure that assets passed to the
PB do not exceed the level of indebtedness to the PB. This entails marking to market on a
daily basis all securities borrowed, adding them to the value of debit balances and comparing
the resulting value to the value of all assets passed to the PB including credit cash balances.
The above limit of 140% for a PIF must be continually observed. Any limits set out in the
Prospectus for a QIF must also be continually observed.
In respect of the inclusion of credit cash balances in the calculation methodology, it is
assumed that cash is held under a banking relationship on the balance sheet of the PB. Where
.cash is held as client money, and as a result the fund is not exposed to the credit worthiness
of the PB, the credit cash balances do not need to be included in the calculation.
"(iii) The PB must agree to return the same or equivalent securities to the
scheme;
This requirement is self-explanatory. Where the PB takes title to assets of the scheme as a
result of the indebtedness of the fund, and the fund requires the return of those assets either
because it wishes to sell them or because there is no longer in debt to the PB, the PB must
return the same or equivalent assets.
The Guidance Note also states that under certain circumstances, "such as an event of default
leading to the termination of the agreement, the PB may elect to return cash in lieu of
securities provided that the PB agrees to indemnify the scheme in respect of any costs, losses

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etc. incurred as a result of such an election (and the right of election will expire in the event
of the insolvency of the prime broker). "
(iv) The arrangement incorporates a legally enforceable right of set-off for the scheme.
This means that in the event of default on the part of the PB to return rehypothecated assets
to the fund, the fund under contractual arrangement has the right to make good such default
by retaining assets borrowed from the PB to the same value of assets rehypothecated and not
returned.
The Guidance Note also states that "Netting arrangements must be recognised under the law
which will govern the insolvency of the prime broker and under the legal location of the
securities in question.
Again this requirement is self-explanatory. Any netting arrangements in respect of assets
owed by the fund to the PB, and the PB to the fund, must be recognised in the domicile of
the PB and in the location of where assets are held.
The Legal Adviser appointed to the Irish fund is required as part of the application
process to confirm to the Regulator that the requirements outlined in this section 2(a) are
incorporated into the text of the fund's agreement with the PB. The majority of Legal
Advisers have expressed concern in this regard, particularly in relation to this point (iv). To
accurately make this confirmation, in their view, a legal opinion would have to be obtained
from a legal adviser in every domicile that securities are to be held, an unworkable and
costly solution.
b) Where the PB will hold assets of the scheme, other than as provided for above, the PB
must be appointed as a sub-custodian by the trustee. While the PB may take a charge over
those assets, the assets must be held in accordance with the provisions of paragraphs 1617, NU 7 of the NU Series of Notices."
This states that the Irish fund trustee must appoint the PB as its global custodian for all assets
owned by the fund other than those that are rehypothecated. The reference to the provisions
of the Notices means that the trustee must treat the PB no differently inters of oversight than
any of its custodians appointed for long only funds. Non-cash assets must be held on a
fiduciary basis, segregated from the PBs own assets and those of its agents, and the
entitlement of the fund to the assets must be assured.
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(c)The PB must be regulated to provide prime broker services by a recognised regulatory

authority, and it, or its parent company, must have shareholders' funds In excess of C200
million (or its equivalent in another currency). In addition, the PB, or its parent company,
must have a minimum credit rating of
Al/Pl.
Draft Guidance Note /04: Other financing counterparties
The Draft Guidance Note also imposes conditions for arrangements with other financing
counterparties, and in particular counterparties to OTC derivative transactions, as follows
A PIF or QIF may enter into arrangements with other counterparties, including counter
parties to OTC financial derivative instruments, provided that:
(a) The counterparty has a minimum credit rating of A2/P2;"
As above this restriction is continual. If the counterparty credit rating drops below A2/P2 the
contract should be unwound.
b) In the case of a PIF, risk exposure to the counter party must not exceed 20% of net
asset value. This limit may be raised to 30% in the case of a credit institution, which falls
under one of the following categories:
- a credit institution authorised in the European Economic Area (EEA);
- a credit Institution authorised within a signatory state, other than a Member State
of the EEA, to the Basle Capital Convergence Agreement of July 1988 (Switzerland,
Canada, Japan, United States);
- a credit Institution authorised in Australia, Guernsey, Isle of Man, Jersey or
New Zealand.
These limits are not applicable to QIFs, but transactions by QIFs with counter parties
which may give rise to counter party risk exposure in excess of 40% of net asset value
must be made in accordance with the conditions applicable to the appointment of prime
brokers, as set out In Section 2 above."

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Generally counterparty exposure limits therefore do not apply to QIFs Where counterparty
exposure is in excess of 40% of NAV, the QIF must comply with the PB requirements set out
above. There must be arrangements in place to mark to market positions daily. There must be
a legally enforceable right of set off. Netting arrangements must be recognised. The rating of
the counterparty must be A1/Pl.
The Guidance Note also states that "a QIF authorised under the Companies Act, 1990 Part
XIII is required to spread investment risk. Proposals to permit counterparty risk exposure in
excess of this amount would appear to offend this requirement."
In this regard, funds established as investment companies cannot have exposures to
counterparties in excess of 40% of NAV. No such limit applies to QIFs established as Unit
Trusts.
(c) Counterparty risk exposure must be measured on an aggregate basis and will include,
for example, exposures arising from investments in securities issued by the counterparty,
amounts held on deposit and OTC derivative positions."
The prospectus for any PIF or QIF that uses OTC derivatives should clarify precisely how
the counterparty exposure is to be measured. Measures may include the gain/loss on the
contract added to any margin deposited with the OTC counterparty. In addition, any other
cash deposits with the counterparty should be included, and any exposures arising out of
direct investments in shares issued by the counterparty.
Draft Guidance Note /04: Compliance with the Guidance Note
Compliance
The Regulator has determined that as the above requirements relate to assets of a fund,
which have passed outside of the custody network, the trustee is best placed to monitor
compliance on an ongoing basis.
The Guidance Note states the following:
"Where a PB is appointed by a PIF or QIF or in the case of counterparty
risk exposure in excess of 40% of net assets, the trustee should confirm that at
a minimum it will:

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(i) receive daily reports from the PB on assets held by the PB outside the custody network
and valuations for those positions;
The reports should demonstrate that the rehypothecation limits for PIFs of 140% of
indebtedness, and the limits set out in the Prospectus for a QIF, are not exceeded. The reports
therefore should compare the value of assets rehypothecated, including credit balances not
held as client money, to the value of securities and cash owed to the PB
(ii) reconcile those positions with its own records, on a nominal basis;
It is understood that the trustees own records are those of the PB as its global sub custodian.
(iii) on each valuation point, reconcile assets on a valuation basis. Where the period
between valuation points exceeds two weeks, the valuations received from the prime
broker should be independently verified.
In terms of valuations, valuations should de reconciled back to the accounting records of the
fund.
(iv) Any discrepancies arising from the reconciliation, which cannot be satisfactorily
resolved with the PB, should be reported to the management of the PIF or QIF requesting
the scheme to take remedial action.
(v) request confirmation from the PB that it does not hold assets other than in accordance
with the requirements of this Guidance Note and the provisions of
the sub-custody agreement "
This confirmation should be requested prior to fund launch and on a periodic basis
thereafter. The reference here to the sub-custody agreement is a reference to the requirement
to hold assets on a fiduciary basis, as above.

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Chapter 19 - Fund Restructure Liquidations / Terminations

After studying this Chapter, you should be able to:
Describe the different types of funds restructures.
Define the Financial Regulator requirements with regard to the winding up of an
investment fund.
Describe the liquidation process of an investment company.

19.1 Fund Restructures

The terms fund transfer, restructures, mergers, amalgamations, schemes of arrangement,
redomicilation are all widely used but sometimes are inaccurate descriptions of what actually
is happening to a fund.
Fund' Mergers' and 'Redomiciliation'
An Irish domiciled fund is one, which typically has been established in Ireland under the
Companies Acts or Unit Trusts Acts. A non-Irish authorised/domiciled fund cannot
"redomicile" to become an Irish domiciled fund. What actually happens in a
"redomiciliation" is that unitholders in fund domiciled/established in another jurisdiction
redeem their holdings in that fund and subscribe for unit/shares in a newly established or
existing Irish domiciled fund.
Similarly where two or more funds 'merge', only one fund will continue to exist after the
merger and one/others will cease to trade and eventually be wound up and de-authorised and
if applicable, de-listed from the Stock Exchange.
The mechanisms by which fund assets are transferred to another fund and units in one fund
exchanged for another are varied. The methods used will have different tax
implications but achieve the same end result. This exchange can be done in a number of
ways, including the following:
where the unitholders of a fund (Fund A) authorise the termination of that Fund A and
authorise the trustee/custodian on their behalf to transfer the assets of Fund A into a new
fund (Fund B) in return for Fund B issuing units to the unitholders of Fund A

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or
where the unitholders of the Fund A authorise a scheme of amalgamation under
which (i) the assets of Fund A would be transferred to Fund B, (ii) the manager of
Fund B issuing units to the persons who are unitholders of Fund A (iii) the manager
of the Fund A cancelling the unitholders' existing units in Fund A.
To affect such fund 'restructures' will usually require a unitholder/shareholder vote. There are
cases for example where the fund manager or board of the investment company take action
without unitholder consent but this is usually limited to a decision to terminate and the Trust
Deed/ Memorandum and Articles/Deed of Constitution must allow for this. In all other cases
unitholders of all affected funds must be given adequate notice of the proposal to consider
and vote of the resolutions. Notice is given in the form of a shareholder/unitholder circular.
The circular will be drafted by the fund lawyers and reviewed by all relevant parties
including the Financial Regulator and trustee/custodian.
In some cases the investors in the Fund may have the option to redeem their investment
altogether rather than transfer or exchange it for shares/units in the other fund.
Financial Regulator Guidance Note 1/03
The Notices requires that the Financial Regulator be notified in advance of proposed
amendments to the constitutional documents, prospectus or third party agreements. The
Financial Regulator may object to the amendments notified to it and amendments objected to
by the Financial Regulator may not be made. The Financial Regulator will continue to
review proposals involving a scheme of amalgamation or termination.
Financial Regulator Guidance Note 1/03 'Amalgamation of Irish authorised collective
investment schemes with other collective investment schemes' contains details of minimum
conditions which the Regulator will require on the proposal for one Irish Fund to merge with
another Irish Fund.
The minimum conditions which the Financial Regulator will require are as follows:
1. In the case of a UCITS, the Fund with which it is intended to merge must also be a

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UCITS.
2. In the case of non-UCITS, the Fund with which it is intended to merge must:
be located in the State, another Member State of the European Union, a Member State of
the European Economic Area ('EEA') (Norway, Liechtenstein, Iceland), Guernsey, Jersey
or the Isle of Man;
not contain restrictions on subscriptions or redemptions which are materially
different to the non-UCITS, including the categories of target investors; and
be authorised and supervised by the relevant competent authority.
CIS which market solely to qualifying, and in exceptional circumstances, professional
investors may be permitted to amalgamate with CIS located in other jurisdictions on a caseby-case basis.
3. In all cases, there must be full disclosure to unitholders of all material facts and
considerations relevant to the proposal by the promoter/management company. The cover
of the circular containing this information must prominently disclose that the information
contained therein is important and that unitholders should take advice if they do not fully
understand it.
The circular must include, inter alia, full disclosure in relation to the following:
i)

the background to and rationale for the proposal;

ii)

a description of the new CIS which must be sufficient to enable unitholders to make an
informed judgement of the proposal being put to them. In particular, this description
should highlight any material differences by comparison with the existing Irish CIS;

iii)

the procedures to be adopted for the transfer of assets;

iv)

the alternatives for unitholders who do not wish to become holders of units in the new
CIS. These unitholders must be offered an opportunity to redeem their holdings in
cash prior to the merger taking effect;

v)

the regulatory status of the new CIS. It should be made clear, where relevant, that the
new CIS has not been authorised by and will not be supervised by the Irish Financial
Services Regulatory Authority;

vi)

details on how unitholders, if they so require, may obtain the prospectus,

constitutional documents and financial statements of the new CIS;

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vii)

all relevant costs including, where applicable, costs associated with the winding up of
the Irish CIS and who will bear these costs (see note 6 below); and

viii) other material information concerning, inter alia, tax treatment4 and details of
the new service providers including their relationship, if any, with the existing service
providers.
4. The trustee of the Irish authorised CIS must review and be satisfied with the proposal and
confirm to the Financial Regulator in writing that it has no objection to the proposal being
put before unitholders for approval.
5. A general meeting of unitholders must be convened to consider and to approve the merger
proposal including, if appropriate, a resolution:
i)

to amend the constitutional document of the Irish CIS to provide that the assets of
the CIS may be passed to a non-Irish trustee to coincide with the time that the
merger becomes effective; and

ii)

to wind-up the existing Irish CIS.

Approval of the proposal will be effective only if:

a) it is approved by not less than three fourths of the votes cast, in person or by proxy, at the
meeting;
b) the votes in favour represent more than half of the total number of units in issue; and
c) provision is made to the effect that the Irish CIS will redeem holdings of all nonvoting
unitholders prior to the amalgamation.
The Financial Regulator may grant a derogation from the provisions of paragraphs (b) and
(c) in the case of mergers of Irish authorised CIS with other Irish authorised CIS, including
mergers of sub-funds within umbrella structures, where both CIS have similar investment
objectives/policies and risk profile.
6. Where the proposal to merge derives from a commercial decision on the part of a
promoter/manager to rationalise its own activities/structures, the promoter/management
company must agree to bear the costs of the merger proposal and arrangements for the
winding-up of the relevant CIS. The Financial Regulator may consider other proposals in
exceptional circumstances.
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7. All unitholders must be notified of the outcome of the general meeting. In the event that
the resolution is passed, unitholders must be advised of the procedures and deadlines by
which they must submit their redemption--request, if they so wish. A reasonable
notification period following the general meeting must be provided to unitholders in order
to consider and submit a redemption request.
8. The provisions of the Guidance Note will also apply in the case of amalgamations of subfunds within umbrella structures.
Notwithstanding the above, the Financial Regulator may refuse to permit any such proposal
to merge/amalgamate to proceed if it is of the opinion that to do so is not in the public
interest, the best interests of unitholders and/or the appropriate and prudent regulation of the
business of CIS. The above guidance paper can be read in conjunction with the IFIA
Guidance Paper in Appendix 11.
Unitholders/Shareholders Acting in Concert
Fund 'restructures' may take place without the need for a formal circular and
unitholder/shareholder resolution, where unitholders/shareholders act in concert and submit a
full redemption of their holdings to be satisfied either in cash or in specie, which in effect
winds up the fund. In practice this is really only an option, in cases of funds with only a few
institutional unitholders/shareholders.
Other Practical Considerations on Fund Mergers Schemes of Arrangement
In reviewing any fund merger proposal a trustee/custodian needs to understand what is
happening. As stated previously there are a variety of ways that a merger can be effected

and this determines the level of involvement needed by the trustee/custodian in

reviewing the arrangements put in place by the manager/board of the investment
company to ensure that unitholders/shareholders are not disadvantaged in the process.
The simpler scenario is where unitholders from one fund redeem and subscribe into an
empty fund i.e. one with no existing unitholders /shareholders.
Where unitholders of a fund(s) (the "dying fund(s)") redeem by taking assets as an inspecie
redemption, leaving a retained amount in the dying fund(s) to discharge liabilities, and
subscribe into another existing fund or empty fund ("the new fund") the main focus of the
manager should be:
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To ensure that all known and anticipated liabilities and costs of winding up the dying fund(s)
are correctly accrued in the final NAV(s) (unless these are being paid directly by the
Manager) and that the retained amount is adequate to meet all liabilities. This final NAV(s)
may/may not be audited.
That the value ascribed to assets for the purposes of issuing units in the new fund is in
accordance with the valuation provisions of the new fund. In the case of an in specie
subscription into a UCIT5 fund" established as an investment company that the value of the
assets received is audited on the subscription date (S30 Audit).
In addition to ensuring that the above items are addressed the trustee/custodian should
review the arrangements in place to address what will be done if there is a shortfall/surplus
on the retained amount. If there is a shortfall on the retained amount, this will normally be
paid by the manager. If there is a surplus on the retained amount this would be distributed to
unitholders of the dying fund(s) unless the cost of distribution is not commercially viable in
such case it would be paid into the assets of the new fund.
It is more complicated where all the assets and liabilities including receivables and payables
of the dying fund are transferred into an already existing fund with its own shareholders or
where two existing funds are transferred into an empty fund. The objective of the manager
and trustee/custodian must be to ensure that no unitholders are disadvantaged in the process
of issuing units by the existing fund or by the new fund.
The manager usually calculates the issue price of units using a conversion factor
spreadsheet. It may well be the case that:
the methodology used in and inputs to the conversion factor spreadsheet,
the reasonableness of the retained amount and
the NAV of the dying funds and existing funds will be audited.

UCITS IV will also introduce harmonised standards across MS in respect of the

requirements governing the merger of UCITS funds.

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19.2 Voluntary Winding up of Irish UCITS and non-UCITS Schemes - IFIA

Guidance Note
Decision to Terminate Scheme
The Financial Regulator notices require that the prospectus give details of the circumstances
in which winding-up of the scheme can be decided on and details of the winding-up
procedure, in particular as regards the rights of unitholders. (non UCITS 9 and UCITS 10).
These circumstances should be consistent with the scheme's Trust Deed/Articles of
Association/Deed of Constitution.
These circumstances may include (but will not be restricted to) the following
considerations;
in the case of closed ended schemes, there may be a finite life for the scheme;
the Net Asset Value of the scheme falls below a certain minimum amount;
the unitholders pass a special resolution to approve the redemption of all the units in
issue;
the trading strategy of the scheme becomes no longer economically viable; and / or,
the scheme is unable to find appropriate service providers to operate as
intended.

The wind-up procedures may include (but will not be restricted to);
basis of allocation of disbursement of assets;
the observance of risk spreading whilst assets are being realised
the rights of the unitholders.
A board meeting approving the termination and setting the termination date needs to be held
and the procedures set out in the Trust Deed/Articles of Association/Deed of Constitution
should be followed in this regard. Once the termination process has been initiated, all service
providers and the unitholders should be informed.
Books of Account
Once a decision to terminate the scheme has. been taken any financial statements based on
the books of account should be prepared on a realisation basis. (FRS18(21)]
For the purposes of dealing date Net Asset Value calculations, any remaining unamortised
formation costs should be written off. Accruals should be considered for the additional costs

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of the termination process. The costs of termination of the scheme will vary depending on a
number of factors but will generally include;
a) the costs of the preparation and audit of termination accounts;
b) the costs of any legal advice in relation to the termination process;
c) for investment companies, the costs of the liquidator;
d) directors fees and expenses;
e) the ongoing costs of the service providers to the scheme during the wind-up process (and
whether NAV based fees, or minimum annual fees are considered appropriate after the
majority of the scheme's assets have been distributed).
All creditors should be contacted and requested to provide details of any outstanding fees or
expenses. It is generally considered good practice to obtain written representation from the
manager or promoter that in the event that any additional unforeseen expenses are incurred
by the scheme in excess of the accrual or creditor provided for in the books of account, that
they will bear these additional costs on behalf of the scheme.
The administrator should keep the books of account open until the scheme has been fully
wound up. Where the scheme is an investment company, the directors will have to consider
the retention and storage of records following the conclusion of the liquidation. Section 305
of the Companies Acts 1963-2001 stipulates that the records of a company and of the
liquidator must be retained for a period of three years following the completion of the
liquidation.
Unlike the procedure for an investment company it is the trustee's responsibility to make the
final disbursements for a unit trust, in this regard it is important that the trustee maintains a
detailed working file in relation to the termination process.
Disbursement of Assets
Generally, it is preferable that the scheme be in cash by the time of the termination. On the
Termination Date, any investments and positions held by the scheme should be closed out.
After payment of creditors, the scheme should distribute the remaining assets to the
unitholders. A distribution should only be made after such form of request from the
unitholder as the trustee/custodian shall in its discretion require.

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Where the scheme holds illiquid assets that cannot be closed out easily after the Termination
Date, an interim percentage of NAV payment to unitholders may be considered appropriate,
with the final payment to be made subsequent to closing out the remaining investment
holdings.- In circumstances where the scheme holds significant illiquid assets which cannot
be closed out within a reasonable timeframe from the Date of Termination consideration
should be given to making an in specie transfer of the illiquid assets.
Delisting from the Irish Stock Exchange
If the scheme is listed, upon appropriate instructions, the Sponsoring Broker should
arrange for delisting from the Irish Stock Exchange. The procedure for delisting is as
follows:
1. A submission (in draft form) is made to the Companies Announcements Office of the
Stock Exchange stating that the directors / manager of the scheme have made an
application to the Stock Exchange for the shares to be removed from the Official List,
stating the reason for the delisting.
2. The Listing Department of the Stock Exchange will then review the draft announcement
and revert with their comments, if any.
3. Once the Listing Department has cleared the announcement, the final announcement
should be submitted to the Companies Announcements Office of the Stock Exchange 48
hours in advance of the proposed delisting date.
4. The Companies Announcements Office process the details and the announcement is
released on the proposed date and the Stock Exchange issue a notice in relation to the
delisting.
Notification of changes in listed directors must be made to the Stock Exchange. This may
become an issue in situations where a number of the directors resign in order to have all or
the majority of the directors in Ireland in order to facilitate the swearing of the declaration of
solvency.
Revocation of Authorisation by the Financial Regulator
Once the decision to wind-up the scheme has been made, the Financial Regulator should
be notified to this effect.

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Monthly returns should continue to be made by the Administrator until revocation of

authorisation has been granted by the Financial Regulator.
When the scheme has disbursed all the assets in accordance with the Trust Deed / Articles of
Association it should seek revocation of authorisation by the Financial Regulator. In order to
issue a notice of revocation the Financial Regulator will require the following information:
a) an indication of what clause of the Trust Deed / Articles of Association/Deed of
Constitution the scheme is being terminated (a copy of the relevant provision should be
attached). In the case of a unit trust, the manager must send the letter applying for
revocation on behalf of the scheme.
b) that the trustee/custodian confirm in writing that final disbursements have taken place and
are in order, that it is not aware of any outstanding claims or disputes with investors or
creditors and, where relevant, that sufficient provision has been made for the costs of
liquidation.
c) audited termination financial statements should be submitted to the Financial Regulator
showing a zero Net Asset Value. These should cover the period from the date of the last
audited financial statements to the Termination Date.
Where the scheme is an investment company, the' Termination Date should be the date of
appointment of the liquidator. If the scheme still has a Net Asset Value that is not zero at the
date of appointment of the liquidator, the Financial Regulator requires in addition to the
termination financial statements, the submission of the liquidator's statement of accounts for
the period commencing from the date of appointment. The liquidator's statement of accounts
is not required to be audited.
The Financial Regulator revokes licences on a quarterly basis. On completion of this process
the Financial Regulator will publish notice of the revocation in Iris Oifigiul and in
a national daily newspaper.
In certain Circumstances, if requested, the Financial Regulator may be prepared to extend the
accounting period required for the interim accounts or annual audited financial statements to
cover the period until the date of appointment of the liquidator.
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19.3 Investment Company Liquidation Process

Before a voluntary winding-up can commence a declaration of solvency (Form No. 12) in
respect of the scheme must be filed with the Companies Registration Office [5 256 of the
Companies Act, 1963 as substituted by 5 128 of the Companies Act, 1990). A majority of the
directors (physically present) at a board meeting must:
-

make a sworn statutory declaration (in the presence of a Commissioner for Oaths) to
the effect that they have made full enquiry into the affairs of the company, and that
having done so, they have formed the opinion that the company will be able to pay
all of its debts in full within a period not exceeding 12 months from the
commencement of the winding up.

the declaration of solvency must include a statement of the company's assets and
liabilities as at a date not more than three months before the making of the
declaration.

the declaration must be supported by a report made by an "independent person",

being a person qualified to act as auditor to the scheme, confirming that the opinion
of the directors on the solvency of the scheme and the statement of the assets and
liabilities contained in the declaration are reasonable.

Notification of changes in listed directors must be made to the Financial Regulator. This may
become an issue in situations where a number of the directors resign in order to have all or
the majority of the directors in Ireland in order to facilitate the swearing of the declaration of
solvency.
An EGM must be convened at a date no later than 28 days after the Declaration of Solvency
is sworn. The declaration of solvency must be delivered to the Companies Registration
Office not later than fifteen days after the EGM.
At this EGM the scheme will be formally placed into liquidation and a liquidator is
appointed. The liquidator replaces the directors and is responsible for discharging all
remaining liabilities of the scheme, for ensuring tax clearance is obtained and for dealing
with the other statutory aspects of the liquidation.

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At the EGM the following resolution should be passed:

-

a special resolution (Le. a resolution requiring the approval of 75% of shareholders)

to wind up the company is passed.

Additional resolutions such as the following may also be passed at the EGM:-

approve the appointment of a named liquidator and fix his remuneration.

authorise the board to send termination notices in relation to the material contracts
(for example the investment management agreement, investment advisory

agreements, custodian and administration agreements).

authorise the board to seek revocation of Financial Regulator authorisation for the
company.

The notice of the EGM must include a copy of the sworn declaration of solvency. Consent
for short notice will be required if less than 28 days notice of the meeting is given.
The company is obliged within 14 days of the passing of the special resolution winding up
the company to publish notice of the special resolution in Iris Ofigiuil which is published
twice weekly.
The appointment of a liquidator is ineffective unless the person nominated has given his
prior consent in writing. If the liquidator is not present at the EGM then he must be informed
within seven days by the chairman of the meeting.
On appointment of a liquidator the fund comes under the control of the liquidator who
proceeds to liquidate the assets, payoff any creditors and, if appropriate, distribute any
remaining assets amongst the shareholders.
The liquidator may if he wishes or if it is necessary, advertise his appointment in two
national newspapers. Advertisements for creditors call are also placed in two national
newspapers, which give creditors 28 days to file their liabilities with the liquidator. At this
point the liquidator will also contact all the relevant parties to inform them of their
appointment and outline their respective duties towards the liquidator.
When the affairs of the company are fully wound up, the liquidator must call a general
meeting of the members to give an account of the winding up and disposal of the property of
the company. This meeting must be advertised in 2 daily newspapers circulating in the

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district where the registered office of the company is situated. Consent for short notice will
be required if less than 28 days notice of the meeting is given.
Within 7 days of the final meeting the liquidator must send a copy of the report and a return
of the meeting to the Registrar of Companies. On the expiration of three months from the
registration of the return, the company is deemed to be wound up and will be dissolved.

19.4 Administrative Issues on Completion of Wind-Up

It should be ensured that all accounts in the name of the scheme have been closed. All
creditors and service providers should be contacted and informed that the scheme has
terminated, and that no further services are required.
Winding up of a Sub-fund in an Umbrella Structure
Whilst such entities do not require the appointment of a liquidator, all other aspects of the
process detailed above will apply including an appropriate accrual for the costs of the
termination process, delisting from the Irish Stock Exchange (as appropriate) and the
requirements of the Financial Regulator for the revocation of authorisation. In the case of a
sub-fund which never launched, audited termination accounts are not required and instead
the Trustee is required to submit a letter to the Financial Regulator confirming that no
units/shares (other than subscriber shares) were ever issued, and therefore there who be no
final disbursement of assets taking place.
Taxation Issues during Wind-up Process
Irish UCITS and Non UCITS schemes qualify as Investment Undertakings as defined in
Section 739B(1) of the Taxes Consolidation Act, 1997 and as such are not chargeable to Irish
tax on income earned or capital gains.
However, the scheme will be registered with the Revenue Commissioner with respect to the
collection of taxes arising on chargeable events as defined in Section 7390(2) of the Taxes
Consolidation Act, 1997. The scheme may also be registered for PAVE / PRSI returns, and
possibly for VAT returns. These returns should be made up to the Termination Date.
The Revenue Commissioner should be contacted in the course of the winding up process to
ascertain whether there are any outstanding tax liabilities. The party contacting the Revenue
Commissioner should at the same time inform the Revenue Commissioner that the Fund is in
the process of winding up.
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Subsequent to the final disbursement of assets, the Revenue Commissioner should be

informed of the effective date of strike off to ensure that the Revenue Commissioner II
amends its records accordingly.

19.5 Change of Custodian/Trustee

The provisions of the custody agreement or trust deed will determine the notification
provisions and other documentation/procedures required to effect a change of
custodian/trustee.

change

of

trustee/custodian

does

not

usually

require

unitholder/shareholder approval but does require an audit. Given the audit requirement a
manager/board of the investment company will generally arrange a change of
custodian/trustee to take place on the fund's financial year end date. If this is not possible, a
change of custodian audit and year end audit will have to be carried out and the annual
financial statements will include two trustee/custodian reports; one from the existing
custodian/trustee from the start of the financial year to the transition date and one from the
incoming trustee/custodian covering the remaining period of the financial year.
From an oversight perspective a trustee/custodian should ensure that responsibility is
clearly assigned in respect of:
- income collection in respect of dividends and other receivables declared and not yet
collected at the transition date
- outstanding corporate actions items
- transactions entered into at the transition date but which have not settled on the transition
date.
The exiting custodian/trustee will provide the incoming custodian/trustee with a listing of the
markets, cash and assets held at transition date. The exiting custodian/trustee will ensure that
all outstanding receivables and corporate action events at the transition are collected and
remitted to the incoming custodian/trustee. Unsettled purchase trades at the transition date
are generally settled by the exiting custodian/trustee and unsettled sales generally settle into
the incoming custodian/trustee.
A change of custodian/trustee is a more labour intensive process for the incoming
custodian/trustee that the exiting one.
The incoming custodian/trustee will have to:
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- re-register the assets, investigate the costs of registration e.g. in some markets assets are
"crossing markets" i.e. assets must be bought and sold on the market to effect reregistration, and liaise with the investment manager as to the preferred course of action.
- Ensure that income listed as being receivable at the transition date is being received into
the fund from the exiting custodian/trustee.
As a matter of best practice the exiting trustee/custodian will usually share with the incoming
trustee/custodian, with the consent of the board of the investment manager/manager, any
open issues or concerns it has with the investment manager/manager/administrator.
In addition, the Financial Regulator requires a confirmation from both the exiting and
incoming trustee/custodian that all the assets of the scheme have been transferred to/received
from the incoming/existing trustee/custodian.

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Chapter 20 - Industry Bodies

After studying this Chapter, you should be able to:
Describe the different industry bodies for the funds industry.

20.1 IFIA
The Irish Funds Industry Association ('IFIA') is the representative body of the international
investment funds community in Ireland, representing the custodian banks, administrators,
managers, transfer agents and professional advisory firms involved in the international fund
services industry in Ireland. Its 80 members and 24 associate members are responsible for in
excess of 10,000 funds with a net asset value of over euro 1.4 trillion. The objective of the
IFIA is to support and compliment the development of the international funds industry in
Ireland, ensuring it continues to be a location of choice for the domiciling and servicing of
investment funds.

20.2 Data
The Depositary and Trustee Association ('DATA') was formed in 1999 and represents the
industry views of depositaries of open-ended investment companies and trustees of unit
trusts within the UK.
Its prime objective is to promote, support, oppose or propose changes in the relevant UK and
EU legislation, in respect of the responsibilities of members of the Association and to
promote and support the development of the depositary and unit trust trustee industry in the
UK. In addition, DATA undertakes to promote and support research, and to coordinate and
support initiatives for the future growth of the industry.
The Association has a corporate structure with its Board of Directors forming an Executive
Committee. The Directors are drawn from and represent the membership of the Association.
The Association is supported by a secretariat function.

Besides the Executive Committee - which meets monthly, there is also a Technical
Committee and numerous specific sub-committees working on industry issues, supported by
the Association's Secretariat. DATA endeavours to represent the industry views to major

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regulatory and influencing bodies such as the Financial Services Authority, the UK Treasury,
the Inland Revenue and the EU Commission.
The Committee also responds to industry developments, particularly concerning new
regulations, market developments and market events.
The representatives of the various organisations who make up the Executive Committee
share resources and responsibilities covering, for example, Capital Adequacy, Single Pricing,
Anti Money Laundering and issues such as the events of September 11th. The Committee
has also reviewed the impact of N2 when the FSA was formed from the previous regulatory
infrastructure of the UK financial markets and the introduction of the new Collective
Investment Schemes Sourcebook.

20.3 ALFI
ALFI (Association Luxembourgeoise des Fonds d'Investissement) is the official
representative body for the Luxembourg investment fund industry and was set up in
November 1988 to promote its development. Its mission is to "Lead industry efforts to make
Luxembourg the most attractive international centre for investment funds"
The four main objectives are:
Help members capitalise on industry trends by providing a framework for information
sharing via meetings, the Internet and the Association's annual conferences and promoting
the visibility of its members;
Shape regulations by working actively with the supervisory body, the government and
law makers when writing EU directives into national legislation or creating a
regulatory framework for specific products so as to defend Luxembourg's competitive
advantage as an investment fund centre;
Encourage professionalism, integrity and quality by offering training and skills
enhancement to industry professionals, by drafting a code of good conduct, transparency
and corporate governance and by supporting the fight against money laundering;
Promote the Luxembourg fund industry by maintaining close relations with political and
economic policy makers at national and European level, by supporting the industry's
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efforts to develop new products, by representing the sector in the context of global
economic missions, by participating actively in industry gatherings at world level and by
building up proactive national and international press relations.
ALFI acts as the platform on which members can discuss key industry issues, reach
common standards, develop best practice recommendations and make joint feedback on
initiatives from the European Commission. All this and more is achieved within the ALFI
Technical Committees, which are open to all members. ALFI carries on an active lobbying
role in Brussels.
ALFI works actively to maintain and raise professional practice standards in the
Luxembourg financial centre, firstly by developing recommendations within Technical
Committees that are then shared with ALFI members by means of Guidelines and Breakfast
Seminars, and secondly by an exclusive contract to deliver technical training through the
IFBL, Institute de Formation Bancaire Luxembourg .
ALFI produces regular newsletters and statistical bulletins and an annual report detailing the
activity of the Association. Product development opportunities are advertised by the
publication of product leaflets. Regular news releases are issued by the ALFI
Communications department.
A key activity of ALFI is promotion of the Luxembourg financial centre. ALFI holds
promotional seminars in cities around the world and participates regularly in the Economic
Missions held by the Luxembourg Chamber of Commerce.
ALFI members have regular opportunities to network both with each other and with potential
clients/providers at the ALFI conferences, ALFI Informal Meetings, within working groups
and at other ALFI events. Career opportunities are regularly posted on the ALFI internet site.

20.4 CESR
CESR is an independent Committee of European Securities Regulators. The role of the
Committee and its operational arrangements are set out in the CESR Charter.
The Committee was established under the terms of the European Commission's Decision of
6 June 2001 (2001/527/EC) . It is one of the two committees envisaged in the Final Report of

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the Committee of Wise Men on the regulation of European securities markets, chaired by
Baron Alexandre Lamfalussy. The report itself was endorsed by Heads of State in the
European Council (Stockholm Resolution of 23 March 2001) and the European Parliament
(European Parliament Resolution of 5 February 2002 Ref: EPResolutions).
In summary, the role of CESR is to:
Improve co-ordination among securities regulators: developing effective operational
network mechanisms to enhance day to day consistent supervision and enforcement of the
Single Market for financial services; Having agreed a Multilateral Memorandum of
Understanding (MoU) , CESR has made a significant contribution to greater surveillance
and enforcement of securities activities;
Act as an advisory group to assist the EU Commission: in particular in its preparation of
draft implementing measures of EU framework directives in the field of securities;
Work to ensure more consistent and timely day-to-day implementation of community
legislation in the Member States: this work is carried out by the Review Panel under the
Chairmanship of CESR's Vice Chairman, and by the two operational groups: CESR-Pol
and CESR-Fin.
The CESR Chair and Vice-Chair are elected from among the Members for a period of two
years. The Committee meets at least four times a year, with expert and operational working
groups of national experts meeting on a regular basis and working at a distance as necessary.
CESR works with the support of a secretariat based in Paris conducted by a Secretary
General.
A representative of the European Commission is entitled to participate actively in all debates
(with the exception of confidential discussions related to individuals and/or firms).

CESR submits an Annual Report to the European Commission, which is also sent to the
European Parliament and the Council. The Chair of CESR reports regularly to the European
Parliament and maintains strong links with the European Securities Committee. All
understandings, standards and work agreed within the Forum of European Securities
Commission (FESCO) have been taken over by CESR.

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The role of CESR and the Lamfalussy Process:

The Committee of Wise Men, chaired by Baron Alexandre Lamfalussy, outlined in its report
of 15 February 2001 several shortcomings in the legislative system for securities. The report
proposed a four level approach with regard to the legislative process in order to solve these
problems. Furthermore, the Committee proposed the creation of the European Securities
Committee (ESC), which primarily has a regulatory function, and CESR which has an
advisory function. The ESC and CESR were formally established in June 2001 and held their
first meetings in September 2001.
The approach proposed can be summarised very briefly as follows: Level 1 measures set out
the high level objectives that the securities legislation must achieve. Level 2 measures set out
some of the technical requirements necessary to achieve these objectives. Level 3 measures
are intended to ensure common and uniform implementation by the use (amongst others) of
common interpretative guidance and standards agreed amongst regulators in CESR. Level 4
measures relate to the enforcement of the legislation. CESR is therefore particularly active in
carrying out functions described under Levels 2 and 3 of the Lamfalussy process.
CESR's Consultation Practices:
The CESR and its Expert and Permanent Groups work in an open and transparent
manner. In its Public Statement of Consultation Practices (December 2001, Ref. CESR/Ol007c), CESR sets out the way in which it will consult extensively, and at an early stage, with
market participants, consumers and end-users. In addition a Market Participants Consultative
Panel has been established to advice CESR on working priorities and assess developments in
the Single Market in the field of Financial Services.

20.5 EFAMA
The European Funds and Asset Management Association (EFAMA) is the representative
association for the European investment management industry.
EFAMA's mission is:
To support a high level of investor protection through the promotion of high ethical
standards, integrity and professionalism in the industry
To promote the completion of an effective single market for investment management and
the creation of a level playing field for competing savings and investment products
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To strengthen the competitiveness of the industry in terms of cost & quality by seeking
and obtaining improvements in the legal, fiscal and regulatory environment
To promote scientific research concerning the industry
EFAMA pursues these objectives through communication and representation to a
variety of bodies and organisations:

The European institutions (Commission, Parliament, Council, CESR)

National legislators and regulators
European associations from other fields (e.g. banking, insurance, pensions)
International bodies (e.g. IOSCO, OECD , IMF, the World Bank) Members of the Press

EFAMA establishes ties with investment fund associations from other countries outside
Europe, in particular the International Investment Fund Association (IIFA)

20.6 NICSA
The National Investment Company Service Association (NICSA) is a not-for-profit trade
association providing leadership and innovation in educational programming and
information exchange within the operations sector of the worldwide investment industry.
NICSA membership totals more than 250 companies operating in major financial centres
in the United States, Europe and Asia. The membership represents all segments of the
mutual fund industry including mutual fund complexes, investment management companies,
custodian banks, transfer agents and independent providers of specialized products and
services.
NICSA's services to members include education, training and networking opportunities
through conferences on a wide range of industry issues and developments; specialized
publications, such as the Transfer Agent Compliance Guide, and access to NICSA's
membership directory. NICSA also offers an Online Learning Centre featuring the
Certified Mutual Fund Specialist Program, the first-ever certification program of its kind.

20.7 AlMA
Founded in 1990, AlMA (the Alternative Investment Management Association) is the only
professional trade association with worldwide membership representing the hedge fund
industry. It has 1,100 corporate members. AlMA addresses the real issues affecting the
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industry's development. Its focus on education, regulation, policy development and sound
practices has resulted in a substantial body of work used around the world by members,
institutional investors, policymakers and regulators. AlMA provides the centre of knowledge
for the hedge fund industry.
AlMA has built an excellent reputation for its professionalism, high quality output and
meaningful dialogue with policymakers around the world.
AlMA's objectives are to:
provide an interactive and professional forum for its membership and act as a catalyst for
the industry's future development;
be the pre-eminent voice of the industry to the wider financial community, institutional
investors, the media, regulators, governments and other policy makers; and
offer a centralised source of information on the industry's activities and influence, and to
secure its place in the investment management community.
AlMA is governed by its Council (Board of Directors).

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Chapter 21 - Regulatory Updates

After studying this Chapter, you should be able to:
Describe the main changes in regulation and the funds industry in the last year.

21.1 UCITS IV
On 19th June 2009 the European Council of Ministers adopted the UCITS IV Directive
Member States will need to enact national legislation to apply the main changes by 1 July
2011. The aim of the directive is to modernise the regulatory framework applicable to these
financial products in order to:
offer investors a greater choice of product at lower cost through better integration of the
internal market;
maintain the competitiveness of European industry by adjusting the regulatory framework
to create a genuine European passport for UCITS management companies
facilitate crossborder marketing of UCITS by simplifying administrative procedures:
there will be immediate market access once the authorisation has been granted by the
country of origin of the UCITS; the host country will be able to monitor the commercial
documents but not to block access to the market;
facilitate crossborder mergers of UCITS, which will make it possible to increase the
average size of European funds
facilitate asset pooling by creating a framework for the system of "master-feeder"
arrangements whereby a fund invests more than 85 % of its assets in another fund;
strengthen the supervision of UCITS and of the companies that manage them, by means
of enhanced cooperation between supervisors: the Directive encourages the exchange of
information between supervisors, harmonises the powers of supervisors, and allows for
the possibility of on-the-spot investigation, consultation mechanisms and mutual-aid
mechanisms for the imposition of penalties, in particular.
Under Articles 16-21 The Right of Establishment and Freedom to Provide Services a
Management Company will be permitted to provide services to UCITS funds established in
another Member State (the Management Company Passport or MCP). These services can be
provided either remotely or by the establishment of a branch in the host member state.
Regardless of whether the management company establishes a branch or provides services in
another member state, the management company will be required to comply with the rules of

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the home member state of the management company as regards the organisation of the
management company (As described in UCITS III Management Directive.)
The MCP should prove beneficial to promoters that operate management companies in a
number of jurisdictions. Reduction in operating costs of management company / economies
of scale, which in turn may reduce Funds Total Expense Ratios. It will also enable
Management Companies to release capital (requirement in Ireland is EUR125,000 initial
requirement plus .02% of AUM managed over EUR250mm). It should also eradicate scope
for protectionist "minimum activity" requirements of member states.
Articles 37-48 introduce the possibility of mergers for UCITS. Mergers shall require prior
authorisation of home member state Regulator (I.e. Regulator of UCITS that will liquidate).
The following must be provided to the Regulator of merging UCITS with the proposed
Terms of the Merger approved by merging and receiving UCITS, an up to date prospectus
and KII of receiving UCITS, a Statement from each depository that they have verified
compliance with aspects of terms of the merger document (type of merger, effective date ad
rules applicable to receipt of units).
Approval of a merger will be passed if it receives 75% approval of unitholders present at
GM. Unlike UCITS III, in which Member States required different approval thresholds there
is no scope for members states to change this criteria. The Directive however is silent on tax
treatment. Until treatment of "chargeable event" is clarified merger activity is likely to be
low.
Articles 58 to 67 introduce Master-Feeder UCITS Structures. The criteria for the feeder is set
to at least 85% of NAV invested in another UCITS. The criteria for the Master is that it must
have a feeder as one of its unitholders, it must not be a feeder itself and must not hold units
of a feeder. Feeder activity requires prior approval of home member state of feeder. The
Directive also states that the master and feeder will be required to make every effort to
coordinate their NAV calculations, and further stipulates that if master liquidates the feeder
must liquidate, unless approval of feeder Regulator is obtained to redirect investment to
another master.
The Potential impact of the Directive is as yet unclear. Rather than reducing the number of
authorised funds it may only serve to increase the number, through the establishment of
feeders in all member states where a product is to be marketed.
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Article 78 Replaces the Simplified Prospectus envisaged under UCITS III with a Key
Investor Information document. Unlike the simplified prospectus, the hard copy KII must
only be provided on request. The KII contents are prescribed and Member states will not
have the scope to insist on disclosures over and above that prescribed by the directive.
Articles 91-96 - allow for the simplification of the cross border notification procedure and is
thus expected to increase the speed to market of new products. A Notification letter should
be sent to the Regulator of the UCITS home state, including the Fund rules, instruments of
incorporation, Prospectus, Annual and half-yearly reports, the KII document and relevant
translation into the language of the target host state. This Information should then be
provided by the home state Regulator to the host state Regulator within 10 working days of
receipt of transmission from the UCITS.
Immediately on receipt, the host state Regulator should advise the UCITS of receipt of this
transmission and at this point the UCITS can be marketed immediately from that date.
The Directive (Article 93(6) states that the host state Regulator shall not request any
additional documents, certificates or information other than those provided for in Article 93.
This will eliminate a common criticism of the current UCITS III regime in respect of
Notification Procedures.
As with all significant changes to the UCITS framework it is not lacking in criticism, and
some of this criticism pertains to the role of the depositary. For example the Directive calls
for an information sharing agreement" between depositories for master and feeder
structures, which has been rejected by IFIA in CESR call for evidence. Similarly, for UCITS
funds which Management Company is not based in the home state, the directive calls for a
point of contact for investors at the home member state, which, it suggests, may be the
depositary. Notwithstanding operational difficulties it has been largely criticized primarily
for the fact that it may present trustees with the potential for conflicts of interest. These
difficulties are expected to be addressed when the Level 2 Measures are published.

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21.2. Proposed Directive on Alternative

Investment Fund Managers
The European Commission published on 30th April 2009 a proposed Directive on
Alternative Investment Fund Managers (AIFM). The proposed directive covers all non
UCITS funds within scope (hedge funds, private equity, commodity etc) and aims to create a
harmonised regulatory and supervisory framework for AIFM in the European Union.
Its aim is "to establish a secure and harmonised EU framework for monitoring and in
supervising the risks that AIFM pose to their investors, counterparties, other financial market
participants and to financial stability", and it establishes controls mechanisms in relation to
the following risks categories:
-

Macro-Prudential Risks (systemic)

Micro-prudential risks
Investor protection
Market efficiency and integrity
Impact on market for corporate control
Impact on companies controlled by AIFM

The proposed Directive will require all AIFM within scope to be authorised and to be subject
to harmonised regulatory standards on an ongoing basis. It will also increase the reporting
and transparency of the AIFM and the funds they manage towards investors and public
authorities. The intention will be to enable Member States to improve the macro-prudential
oversight of the sector and to take coordinated action where necessary with regard to the
proper functioning of financial markets.
The proposed AIFM Directive will:
Adopt an 'all encompassing' approach so as to ensure that no significant AIFM is outside
of regulation and oversight, while providing exemptions for much smaller managers. The
Directive will only apply to those AIFM managing a portfolio of more than 100 million.
A higher threshold of 500 million applies to AIFM not using leverage (and having a five
years lock-in period for their investors) as they are not regarded by the Commission as
posing systemic risks. According to analysis by the Commission, a threshold of 100
million implies that roughly 30% of hedge fund managers, managing almost 90% of
assets of EU domiciled hedge funds, would be covered by the Directive.
Aim to regulate major sources of risks in the alternative investment value chain by
ensuring that AIFM are authorised and subject to ongoing regulation and that key service

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providers, including depositaries and administrators, are subject to robust regulatory

standards, which is currently the case in Ireland.
Increase the transparency of AIFM and the funds they manage towards supervisors,
investors and other key stakeholders.
Ensure that all regulated entities are subject to governance standards and have robust
systems in place for the management of risks, liquidity and conflicts of interest.
Permit AIFM to market funds to professional investors throughout the EU subject to
compliance with regulatory standards.
Grant access to the European market to third country funds after a transitional period of
three years. The Commission have said this is to allow the EU to check whether the
necessary guarantees are in place in the countries where the funds are domiciled (with
respect to equivalence of regulatory and supervisory standards, exchange of information
on tax matters).
The proposed directive is with the European Parliament and Council for consideration and
with respect to timeframe for implementation it is noted that if political approval on the
Commission's proposal is reached by the end of 2009, the Directive could come into force in
2011. Industry activity has commenced to consider the implications and ramifications of the
proposed Directive and this process continues.

21.3 CESR's Advice on Risk Management

Principles for UCITS
In February 2009 with respect to the introduction of UCITS IV, the European Commission
requested CESR to provide advice on the required and -relevant implementing measures, as
part of this process and to prepare the implementing measures CESR have scheduled a series
of consultation papers. The first of these, the Consultation Paper on Risk Measurement for
the purposes of the calculation of UCITS' global exposure, was issued on 15th June 2009.
The paper is composed of 52 individual questions and examines the methodologies and
concepts used in the measurement and calculation of risks as they apply to UCITS under the
following areas:
1. Calculation of global exposure using commitment approach
2. Calculation of global exposure using VaR (Value at Risk) models relating to both relative
and absolute VaR limits
3. Calculation of OTC counterparty risk exposure and the treatment of collateral

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4. How the above methodologies apply to the concept of Sophisticated vs. Non
sophisticated UCITS.
The Consultation Paper will be most relevant to parties who are responsible for and who
prepare risk measurement and risk management of UCIT funds.
This consultation paper follows a set of Level 3 principles issued by CESR in February 2009
which are designed to help foster convergence amongst competent authorities and provide
guidance for market participants in respect of risk management techniques applied to
UCITS. The principles set out apply to both management companies and self-managed
UCITS. The detailed principles are arranged around the following areas:
-

Supervision by competent authorities

Governance of the risk management process
Identification & measurement of risks relevant to UCITS
Management of risks relevant to UCITS
Reporting & monitoring

21.4 Extension to the Regulatory Deadline for Filing of Audited Accounts

The financial market conditions have created challenges for investment funds world-wide
and these challenges are particularly relevant for funds of funds/feeder funds, where these
funds are holding investments in funds that have suspended redemptions and/or have an
increased uncertainty over the accuracy and appropriateness of the valuations of the
underlying investment fund. These challenges are particularly apparent at year-end and
impacts the production of year-end financial statements. Noting these challenges, Industry
wrote to the Financial Regulator on the 6th March 2007 and then met with the Financial
Regulator on the 17th April 2009 to discuss the possible extension of the regulatory filing
deadline for Irish registered funds of funds, so as to allow the necessary time to obtain
sufficient support for the figures and disclosures in their financial
statements, and to have a statutory audit completed .
On 21st April 2009 Financial Regulator confirmed that the Financial Regulator is willing to
grant a derogation for the filing of audited accounts in respect of Non-UCITS investment
funds structured as fund of funds/feeder fund from 4 to 7 months subject to the following
conditions:
Given the provisions of collective investment scheme legislation, the derogation can only be
granted with respect to investment companies.

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The derogation will only be considered while difficulties incurred in the current market
remain;
The derogation will only be considered for non-UCITS funds of funds/feeder funds; and
A derogation request must be submitted by each individual fund requiring an extension to
its filing deadline.

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Chapter 22 - The Role of the Financial Regulator and the Stock Exchange
After studying this Chapter, you should be able to:
Describe the role of the Financial Regulator with regard to the regulation of funds
launched in Ireland.
Identify the role of the Irish Stock Exchange in listing Funds.
Outline the documentation required for establishing an investment fund in Ireland.

22.1 The Role of the Financial Regulator

The Financial Regulator acts as the regulator of the offshore funds industry in Ireland. There
are two main categories of funds authorised by the Financial Regulator UCITS and NonUCITS. The legislative basis for the Financial Services Regulators supervisory function in
relation to Collective Investment Scheme is set out in several Government Acts/Regulations
dating from 1989 and which are detailed as follows:
Companies Act, 1990: Part XIII of the Companies Act, 1990 provides the Financial
Regulator with the power to regulate variable capital investment companies (nonUCITS).
Unit Trusts Act, 1990: Sections 3 and 4 of the Unit Trusts Act, 1990, provides the
Financial Regulator with the power to regulate unit trust schemes (non-UCITS).
UCITS Regulations: The 2003 Regulations as amended provides the Financial Regulator
with the power to regulate all collective investment schemes which qualify as UCITS.
Central Bank and Financial Services Authority of Ireland Act, 2003: Establishes the
Central Bank and Financial Services Authority of Ireland.
Central Bank and Financial Services Authority of Ireland Act, 2004: Establishes the
Office the Financial Services Ombudsman and augments the enforcement powers of the
Central Bank and Financial Services Authority of Ireland.
The regulation of a fund consists of a detailed assessment of the promoter and other parties
related to the fund. It also involves the imposition and enforcement of detailed supervisory
requirements which are set out in Notices devised by the Financial Regulator and which
cover, inter alia, investment and borrowing restrictions and disclosure of information to
investors.

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Guidance Notes are issued by the Financial Regulator, from time to time, to provide
direction on issues relating to the funds industry. Notices and Guidance Notes are drawn up
after consultation with the Funds Industry particularly the Irish Funds Industry Association
(IFIA) a representative body comprising the industry itself and legal and accounting firms
involved in the industry.
The above statutory provisions contain broadly similar frameworks of regulation for each of
the different types of collective investment schemes which can be summarised as follows:
The scheme shall not carry on business in the state unless it has been authorised to do so
by the Financial Regulator.
An investment company (or management company of a unit trust scheme) must have a
paid-up share capital sufficient to enable it to conduct its business effectively and meet its
liabilities.
An application for authorisation shall be made in writing to the Financial Regulator and
shall contain such information as the financial Regulator may specify.
The Financial Regulator may impose such conditions on the granting of an authorisation
as it considers appropriate and prudent, including:
o The prudential requirements of the investment policies of the scheme.
o Prospectuses and other information published by the scheme.
o The safekeeping of the assets of the scheme with a trustee/custodian.

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Chapter 23 - Other Jurisdictions and Marketing of Funds

After studying this Chapter, you should be able to:
Compare the different features of funds authorised in jurisdictions outside Ireland and the
different regulatory regimes applying to each.
Describe the marketing process of Irish funds abroad and foreign funds in Ireland.
In this course, we have largely concentrated on funds authorised in Ireland by the Financial
Regulator. However, many Irish service providers also act for funds domiciled in other
locations. The reasons why a fund might be domiciled elsewhere but still administered in
Ireland include:
Avoiding the expense and inconvenience of complying with a strict regulatory regime;
Speed of establishment / authorisation;
The promoter may not have the tract record required by the Financial Regulator
The fund may not be of a type that will be approved by the Financial Regulator;
and
The purpose of this section is to look at some of the more popular jurisdictions for
establishing funds and to describe their main features.

23.1 Luxembourg
Like Ireland, Luxembourg is a member of the EU but it has a much longer tradition as a
financial services centre (the first fund was established in Luxembourg in 1929.

The

government of Luxembourg has made considerable attempts to attract international financial

services business, including funds, creating a favourable tax regime. The Commission de
Surveillance du Secteur Financier (Luxembourg Commission for the Supervision of the
Financial Sector CSSF), like the Financial Regulator in Ireland, provides the necessary
regulatory oversight.
Because of its history and geographical location and its Civil law system, Luxembourg is
especially popular with fund promotes in France and Germany, offering not only UCITS
funds but also a similar legal system to the one found in those countries as well as certain
banking secrecy laws.

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The Law of 20 December, 2002, relating to Undertakings for Collective Investments (the
2002 Law) and which was passed to implement Directives 2001/107/EC and 2001/108/EC,
effectively introduces UCITS III and replaces the previous 1988 laws which introduced the
UCITS Directive.
Part I of the 2002 Law regulates UCITS which must be open ended, comply with the
stringent requirements set by the EU legislation (in terms of eligibility of assets, risk
spreading, prohibition of leverage, requirement for a Risk Management process and sets out
requirements in respect of substance and supervision).
Part II of the 2002 Law covers funds which are not covered as UCITS. In other words, this
will cover funds whose investment policy or risk spreading is not compliant with the UCITS
requirements, or they use leverage not permitted by the Directive, or they do not actively
market their shares to the public in the EU, or they are not open for redemptions as would
typically be required for a UCITS Funds (a UCITS Fund must allow redemption at least
twice during a calendar month).
Luxembourg created a Specialist Investment Funds law (passed in February 2007 the SIF
Law) which replaced the law of 1991 on institutional funds. The SIF law permits funds to
be established which allow shares or units to be sold to well informed investors i.e. other
institutions, large corporate or individuals which are ready to certify that they adhere to the
status of well informed investor and who invest a minimum of Euro 125,000 in a SIF, or
alternatively obtain an assessment from a regulated entity certifying their expertise,
experience, and knowledge in assessing the risk of their investment).
In June 2004, Luxembourg passed a law relating to investment into risk capital (SICAR),
which creates a favourable tax regime for vehicles which technically are not investment
funds, but which resemble their functioning. The SICAR, which is exclusively reserved for
well-informed investors are prime vehicles for investing into Private Equity and venture
capital.
Typical fund structures in Luxembourg are: (i) Fonds Commun de Placement (FCP) which
resemble a Unit Trust and (ii) Investment Company with Variable Capital (SICAV) which
is equivalent to VCC.
The industry is represented by the Luxembourg Investment Fund Association (ALFI),
(playing the same role as the IFIA).
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23.2 The Cayman Islands

The Cayman Islands is one of a number of Caribbean centres, such as the Netherlands
Antilles and the British Virgin Islands, where the level of regulation of funds is minimal,
compared to jurisdictions such as the UK and Ireland.
Unlike some of the EU jurisdictions, there is no requirement to have a locally based
custodian or administrator. The Investment Fund laws are drafted to have a locally based
custodian or administrator. The Investment Fund laws are drafted on the basis that the
service providers are already regulated and hence rely to a large extend on self regulation.
Furthermore, there are no restrictions placed on investment objectives, investment
restrictions, techniques and instruments for efficient portfolio management given the
institutional nature of investors in Cayman Funds.
In 1993, the Cayman Islands enacted the Mutual Funds Law. The law covers both mutual
funds and those having control over a mutual funds assets.
The common investment vehicles employed are investment companies, unit trusts or limited
partnerships, which may be formed under either Cayman Islands law or the laws of another
jurisdiction.
There are four types of mutual funds
(1)

Exempted mutual funds:

Private equity funds will be exempted from compliance

with the Mutual Funds Law if the equity interests are held by not more than 15
investors, the majority, in number, of whom are capable of appointing or removing the
operator of the mutual fund (i.e. the directors of a company, the trustee of a unit trust
or the general partner of a partnership).
(2)

Registered mutual funds:

Registered funds are the most common form of mutual

funds regulated under the Mutual Funds Law. A mutual fund will be a registered
mutual fund if: the minimum subscription per investor is at least USD 100,000 (or
equivalent) or the equity interests are listed on a stock exchange approved by the
Authority. A registered mutual fund is not required to be licensed. Instead, it is only
required to register its offering memorandum and certain prescribed details relating to
the offering of its equity interests with the Authority.
(3)

Administered mutual funds: A mutual fund will be an administered mutual fund if its
principal office in the Cayman Islands is provided by a licensed mutual fund
administrator. Administered mutual funds must file an appropriate offering document
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and certain other relevant details with the Authority, together with all changes and
supplements thereto. Annual accounts audited by approved Cayman Islands based
auditors must be filed within 6 months of the relevant financial year-end.
(4)

Licensed mutual funds:

Licensed mutual funds are the rarest form of mutual funds

regulated under the Mutual Funds Law. A licensed mutual fund is a mutual fund that
is licensed under the mutual funds law. Unless a mutual fund falls within one of the
above three categories, it must obtain a mutual fund licence. All licensed mutual
funds must have a registered office in the Cayman Islands or, in the case of a unit
trust, have a trustee licensed under the Banks and Trust Companies Law.
Other benefits of establishing a Cayman Islands Investment Fund is that it is a no tax
jurisdiction and enjoys a flexible and efficient regulatory process. Also, the Cayman
Islands offers investment funds the opportunity to list on the Cayman Islands Stock
Exchange.

23.3 Jersey
The Jersey Financial Services Commission (the Commission) is the chief regulatory body for
Funds in Jersey.

The Commission is responsible for the regulation, supervision and

development of the financial services industry in the Island of Jersey including the regulation
of the Funds industry.
Collective investment funds and service providers and functionaries thereto are regulated
under the provisions of the Collective Investment Funds (Jersey) Law 1988.
Jersey funds normally take the form of (1) Jersey law unit trust (2) a Jersey incorporated
investment company or (3) a Jersey registered limited partnership.
Fund vehicles can be either open-ended or closed-ended. Where a fund is open-ended, a
Jersey resident manager and a Jersey resident custodian must be appointed for the fund save
where it qualifies for certain exemptions from the custodian requirements in Jersey as et out
in the Commissions Guide to Jersey Expert Funds or its Jersey Listed Fund Guide. If a fund
is closed-ended, there is no requirement to appoint a Jersey resident custodian although a
Jersey resident manager is still usually required.
The general types of Collective Investment Funds in Jersey include:
Private funds: Private investment funds for the use of a single specified corporate group or
institution or small group of sophisticated investors can be established very rapidly, at

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reasonable cost and with little or no regulatory supervision. Private funds must be closelyheld amongst a small group of co-investors not exceeding fifteen in number. Such funds fall
outside the regulatory controls of the Collective Investment Funds (Jersey) Law, 1988, as
amended (the 1988 Law).
Private placement funds:

This covers funds for limited participation by a number of

institutional or sophisticated high net worth investors. Provided that the number of offering
documents and the ultimate number of investors does not exceed 50 persons (and subject to
compliance with certain other marketing procedures set out in the 1988 Law), these private
placement funds will also fall outside the full regulatory controls imposed under the 1988
Law.
Unclassified funds: This covers funds which have as an object the collective investment of
capital acquired by means of an offer to the public offering, in particular an offering to more
than 50 persons or where the securities to be issued by the fund will be listed. These funds
fall within the statutory definition of a collective investment fund for the purposes of the
1988 Law and are subject to the Commissions supervision.
Expert and Listed Funds:

For Unclassified Funds which meet the criteria to qualify as

Expert Funds or Listed Funds and expedited regulatory procedure is available.

An

investment fund constitutes and Expert Fund if each investor signs and investment warning
and falls within a certain criteria including, inter alia, a person who makes a minimum initial
investment of $100,000 (or currency equivalent); or a person whose ordinary business
includes buying or selling investments or giving investment advice; or a person with a net
worth (individually or jointly with their spouse) of more than $1 million (or currency
equivalent) excluding their place of residence).
Unregulated Funds:

Funds which meet the criteria to qualify as Unregulated Eligible

Designated Territory status under the United Kingdom Financial Services and Markets Act,
2000 (the FSMA) so that they may be marketed freely to the public in the United Kingdom
under the FSMA, subject to compliance with United Kingdom regulatory marketing
requirements.

23.4 Marketing Irish Funds Abroad

Generally, fully regulated jurisdictions restrict the marketing of foreign funds to their
residents. In most cases, this means that in practice, a foreign fund cannot be marketed to
the public in these countries, although it is usually permissible to sell units or shares through

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stockbrokers, financial advisers and other investment professionals or sometimes directly to

sophisticated investors. Marketing to the public in this context means advertising, issuing a
prospectus directly to the public, taking orders directly from members of the general public,
and so on.
However, there are exceptions, principally where some form of mutual arrangement exists
between two or more countries to recognise funds established in the other. The most obvious
example is UCITS funds, which may be marketed to the public in any EU-member state,
subject to complying with local marketing requirements.
These requirements typically consist of making copies of the funds documentation available
in the language of the relevant country and appointing a local representative or paying agent
to deal with queries from investors in that country and provide facilities for investors to
collect the proceeds of their investment from a bank in that country.
The UCITS directive also provides for a two-month period after notifying the authorities in
the relevant member state of an intention to market the shares or units of the UCITS fund in
that state, during which the authorities may consider the application. If the authorities do not
approve the marketing of the fund within this period, the fund will automatically be entitled
to market on the expiry of the two-month period.
In addition, the Irish authorities have concluded formal agreements with the authorities in
Jersey, Guernsey, and the Isle of Man whereby Irish UCITS funds may be authorised to
market to the public in those jurisdictions. Other regulated jurisdictions which accord
regulatory recognition to Irish-authorised funds include Japan (UCITS only), Hong Kong
(UCITS and non-UCITS retail funds), Switzerland, and Bermuda.
Theory however is different to reality as despite the passport to market throughout Europe,
certain visa requirements, which are different in each Member State, have developed over
the years. These provide a significant barrier to a single European market and add to costs
for investors and limit the choice available to them. However, in the advent of UCITS IV, it
is proposed that funds established in one member state can be marketed in another member
state within 10 days of notification to Regulator of Home State of the UCITS.

23.5 Marketing Foreign Funds in Ireland

In common with other countries, Ireland requires foreign funds to obtain approval before
they can be marketed to the public in Ireland, although marketing through financial

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intermediaries and other investment professionals on a private placement basis is not

controlled in the same way.
Foreign Non-UCITS Funds
The Financial Regulators Non-UCITS Notice 19 relates to collective investment schemes
which propose to market their shares in Ireland. The Notice states that the collective
investment scheme must be authorised by a supervisory authority set up in order to ensure
the protection of shareholders and which, in the opinion of the Financial Regulator, provides
a similar level of investor protection to that provided under Irish laws, regulations and
conditions governing collective investment schemes. Alternatively, the Financial Regulator
must be satisfied that the management and trustee/custodial arrangements, constitution and
investment objectives of any scheme which it is proposed to market in Ireland provide a
similar level of investor protection to that provided by schemes under the Irish laws,
regulations and conditions governing collective investment schemes.
A collective investment scheme situated in another jurisdiction and which proposes to
market its share in Ireland must make application to the Financial Regulator in writing,
enclosing, inter alia, the full name of the scheme, the full name and address of the operator,
the full name and address of any supervisory authority or authorities to which the operator is
subject in the state in which the operator is established, the full name and address of the
establishment in Ireland (or facilities agent) where (a) facilities will be maintained where
shareholders can obtain payment of dividends and redemption or repurchase proceeds, (b)
the instrument(s) constituting the scheme, the prospectus, the annual and half-yearly reports
can be examined, free of charge, and copies obtained if required; and (c) complains can be
made for forwarding to the head office of the operator.
The Financial Regulator will also require certain documentation including a statement or
certificate from the supervisory authority of the scheme confirming that it is authorised, a
certified copy of the fund rules or instruments of incorporation, the prospectus and any
amendments thereto, the latest annual report and any subsequent half-yearly report, a copy of
any other document affecting the rights of shareholders in the Scheme, confirmation from
the facilities agent that it has agreed to act for the Scheme. All documentation submitted to
the Financial Regulator must be in English or Irish or must be accompanied with a
translation in English or Irish.
Collective investment schemes which are one of the following:
established in Guernsey and authorised as Class A Schemes;

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established in Jersey and authorised as Recognised Funds;

established in the Isle of Man as Authorised Schemes.

Will receive approval to market their shares in Ireland on completion of the information and
documentation requirements. In all other cases, the marketing of shares in Ireland may not
take place until the scheme has received a letter of approval from the Financial Regulator.
Collective investment schemes marketing their shares in Ireland must comply with the
provisions of the Code of Advertising Standards for Ireland and schemes marketing their
shares in Ireland must comply with all other laws, regulations and administrative provisions
in force in Ireland.
When a collective investment scheme has received approval from the Financial Regulator to
market shares in Ireland, the name of the scheme and the name and address of the facilities
agent will be placed on a list of schemes marketing in Ireland, which will be made available
to the public on request.
Foreign UCITS Funds
The Financial Regulator UCITS notification procedures are consistent with CERSs 2006
Guidelines mentioned above. A UCITS situated in another EU member state which proposes
to market its shares in Ireland must submit the following documents to the Financial
Regulator:
standard form of notification letter (as provided for in CESRs guidelines;
attestation by either its home regulator or the UCITS itself that it complies with the
UCITS Directive;
its current constitutional documents;
its current prospectus;
its current simplified prospectus;
its latest annual report and any subsequent half-yearly report; and
details of the arrangements made for marketing its shares in Ireland (the UCITS must take
adequate measures to ensure that facilities are available in Ireland for making payments
to shareholders, repurchasing shares and making available to shareholders all to which
they are entitled).

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The Financial Regulator will process application within two weeks provided the notification
is complete. The UCITS may commence its marketing when informed the UCITS that the
application has been completed or within two months from the date on which the complete
notification was submitted to the Financial Regulator (unless the Financial Regulator has
communicated to it that the application is incomplete).

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Chapter 24 Complex Bonds

After studying this Chapter, you should be able to:

Describe the core characteristics of bonds
Identify the uses of the different types of complex bonds
Describe the pricing, valuation and disclosures for these complex bonds

24.1 Overview of Bond Characteristics

a) Definition
A bond is simply a variety of loan. It entitles the owner to interest (or Coupon) and when ~ it
matures the holder receives back the original at par. What distinguishes bonds from bank
loans is their transferability.
It is a financial instrument, usually long-term, which is similar to an IOU. When you
purchase a bond, the issuer (can be a government, bank or corporate) is promising to pay you
face value (i.e., the principal) at maturity and, in the majority of cases, interest on a periodic
basis.
A bond however need not be held to maturity it may be sold at any time provided an
adequate secondary market exists. Bonds therefore have the advantage of long term
borrowings for the issuer while maintaining a high degree of liquidity to the lender.
Buying into a bond issue will usually require a larger up-front commitment of capital than
buying into an equity.
b) Key Characteristics of Bonds
Interest / Coupon
Reflects the interest rate at the time of issue
May be fixed, floating or indexed
Shares Par
The number of bonds purchased or owned by the bondholder. Bonds are usually sold in lots
of 1,000. This can also be referred to as Face Value.
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Bond Pricing
Bond prices are quoted in pennies or percentage terms e.g., if a 1,000 bonds are quoted at 99,
the bond is worth 1,000 * .99 = 990.
Quoted at 100, this is referred to as 'par'.
Quoted greater than par (i.e., >100), it is referred to as 'pricing at a premium'.
Quoted lower than par (i.e., <100), it is referred to as 'pricing at a discount'
Bond prices are usually quoted "clean", i.e., without accrued interest. The clean price is, in
effect, the price of the bond on the first day of the coupon period. The "dirty" price of a bond
is, therefore, the price of a bond including accrued interest.
Bond prices depend on a variety of factors, such as:
-

interest rates
maturity
supply and demand,'
credit quality

Newly issued bonds generally sell at or near their face value, i.e. a price of 100. Bond prices
have an inverse relationship with interest rates. If interest rates move up, bond prices move
down and vice versa.
Principal Amount
This is the total monetary amount that the bondholder pays for the bonds. It is calculated by
multiplying the number of shares/par by the price paid. If bought at 100, the principal will be
the same at the number of shares/par bought.
Coupon Frequency
This is when the bond holder will receive cash payment. This can take place
Annual
Semi Annual
Other - quarterly, monthly

Interest Accrual method

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Depending on the bond type, there are several different methods that can be used to accrue
income. For example 30/360 and Actua1/365.
Maturity
This is the date when the bondholder will receive the maturity amount of bond. This can be:
Single redemption amount on one date
Redemption between two dates
c) Risk associated with Bonds
Typically Bonds have been regarded as the safer type of investment tool. However there are
certain risks associated to bonds:
Interest Rate Risk
Bond fund returns are highly dependent on the changes in general interest rates that is,
when interest rates increase, the value of bonds decrease, which in turn affects returns on
a bond (and ultimately returns on a fund investing in bonds).
Credit Risk
While lower-credit-quality bonds bring higher yields, they also bring higher volatility.
Foreign Exchange risk
Foreign currency exposure is applicable when a fund invests in bonds that are not
denominated in its domestic currency. As currencies are more volatile than bonds,
currency returns for a foreign currency bond could potentially end up dwarfing its fixedincome-return.

24.2 Credit Rating and Credit Rating Agencies

a) Credit Rating
The credit quality of bonds varies from the highest quality government bonds, to junk bonds
that are rated below investment grade.
Generally speaking, bonds with good quality credit ratings trade at a lower yield than bonds
with poorer credit ratings.
This is because investors expect a higher return for the greater risk of investing in bonds with
an increased chance of default on behalf of the issuer.

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Government Bond

Corporate Bond

Junk Bond

Deemed safest

Safe

Risky

b) Credit Rating Agencies

Credit ratings are usually supplied by international rating agencies such as Moody's Investor
Services and Standard & Poor's (S&P), who make independent assessments of an issuer's
ability to fulfil the obligations on its debt.
Ratings range from the highest quality, minimum investment risk bonds such as AAA with
S&P and Aaa with Moody's, to poor quality, non-investment grade bonds such as BB issues
and below with S&P and Ba issues and below with Moody's.
A Bond can be downgraded in its rating if something happens to the credit worthiness of the
underlying company. Or as been shown with the recent downgrading of Irish government
bonds by S&P as it was felt that the Irish taxpayer would have to bear even higher costs in
supporting the country's banks could negatively impact on the Irish Governments ability to
repay their bonds.
This has a significant impact on the issuer, as the lower the credit rating, the higher interest
rate may need to be offered to attract investors.
.
c) Fallen Angels and Rising Stars
Fallen Angels - This is a bond that was once investment grade but has since been reduced to
junk bond status because of the issuing company's poor credit quality.
Rising Stars - The opposite of a fallen angel, this is a bond whose rating has been increased
because of the issuing company's improving credit quality. A rising star may still be a junk
bond but on its way to being investment quality.

24.3 Mortgage-Backed Pass-Through Securities

a) Definition of Investment Characteristics

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The following quotations, taken from "The Handbook of Mortgage-Backed Securities" by

Frank J. Fabozzi summarise the basic technology and characteristics of common mortgagebacked securities.

Pass-through Securities
"Pass-through securities are formed when mortgages are pooled together and undivided
interests in the pool are sold. The sale of the pass-through security represents a sale of assets
and is not a debt obligation of the originator. The cash flow from the underlying mortgages is
'passed through' to the holders of the securities in the form of monthly payments of interest,
principal and prepayments. Prepayments occur when the holder of an individual mortgage
prepays the remaining principal before the final scheduled payment month".
Government National Mortgage Association (GNMA) Pass-through Securities
"The mortgage pools underlying GNMA pass-through securities are made up of FHAinsured or VA-guaranteed mortgage loans. GNMA pass-throughs are backed by the full faith
and credit of the United States Government. The GNMA pass-through security is a fully
modified pass-through security, which means that regardless of whether the mortgage
payment is received, the holder of the security will receive full and timely payment of
interest and principal and interest.
"While providing the same guarantees as all GNMA certificates, GNMA IIs are based on
multiple issuer pools while the original GNMAs are based on single issuer pools. In addition,
the mortgage coupon requirements have been relaxed (a wider range of coupons is permitted
in a pool), and there is an additional delay of five days in passing through principal and
interest payments because of centralisation of the payment facility.
"The GNMA GPM pass-through security is based on graduated payment mortgages. This
market is smaller and less liquid than fixed-rate single-family GNMAs. In addition, the cash
flows are more complex and amortisation is initially negative. It should be noted that the
GPM becomes the equivalent of a fixed rate, fully amortising, level payment mortgage after
five years."

Federal Home Loan Mortgage Corporation (FHLMC) Participation Certificate (PC)

"The FHLMC (commonly known as Freddie Mac) is the second largest issuer of passthrough securities. Their PC is based upon conventional mortgages (that is, single family

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residential mortgages that are not guaranteed by VA or insured by FHA) ... FHLMC
guarantees only timely payment of interest and ultimate payment of principal. This means
that FHLMC passes through whatever principal it collects and guarantees payment of the
remainder within a year".
Federal National Mortgage Association (FNMA) Mortgage Backed Securities
"FNMA commonly known as "Fannie Mae" guarantees the timely payment of principal and
interest for all securities it issues."
b) Terminology
Factor: A seven or eight place decimal number which indicates the proportion of the
original face value of a certificate which is still outstanding principal balance in decimal for
n. At issuance a bond's factor is 1.000000.
Original Face or Par Value: The face or par value of a bond at issuance.
Current Face or Par Value: The original face or par value of the bond, reduced by the total
amount of principal repayments received during the life of the bond to date.
Paydown: The monthly payment to the bondholder, which consists of principal repayments
and interest payments on the current face value.
Payup: In the initial years after the issuance of some bonds, such as GNMA GPMs, monthly
interest payments to the bondholder are less than the total amount of interest accrued. The
excess of accrued interest over paid interest is added to the face value of the bond.
Generic GNMAs: Many GNMA trades are initially stated in terms of generic GNMAs, in
which bonds with the same coupon rate are grouped together. When GNMAs are traded on a
generic basis, the specific pools to be delivered at settlement are identified 48 hours before
settlement.
Good Delivery: In order for the delivery of bonds to be considered a "good delivery" the
specific GNMA pools selected to settle a trade, initially stated in generic terms, must
conform to certain specifications agreed upon as part of the trade. These specifications will
vary from situation' to situation, but might include the following:

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a maximum of a +/- 5% difference between the total par value delivered and the par value
initially agreed to as part of the trade
a maximum of 3 pools delivered per $1 million of par value.
c) Paydown Delay
The following quotation, taken from "The Handbook of Mortgage-Backed Securities" by
Frank J. Fabozzi describes the payment delay inherent in mortgage-backed pass-through
securities:
"There is an initial payment delay with mortgage-backed pass-through securities. The first
mortgage payment is not due from the homeowner until the beginning of the second month
after origination. The holder of the corresponding pass-through does not receive his first
payment, however, until sometime into the second month.
"An investor in a GNMA single family pass-through, for example, does not receive payment
until the 15th day of the second month from origination. A GNMA trader will express this 15day delay as a 45-day delay, indicating the time frame from origination to first payment. The
FNMA security has a stated delay of 54 days. This means the first payment takes place on
the 24th day of the second month. A FHLMC security has 75-day delay."
Accounting for Paydowns
There are three key dates to consider when accounting for paydowns:
Effective Date: The date when the reduction in the outstanding principal balance, resulting
from the principal paydown is reflected in the security's interest accruals.
Receipt of Factor Information: Paydown factors for the current month's paydown
payments are typically available during the first two weeks of the month.
The receipt of actual factors taken together with the known history of the pool, provides
sufficient information to account for the principal payments and to determine the new
interest accrual amounts.
Receipt of Interest and Principal Payments: monthly principal and interest payments are
received during the third and fourth week of the month. The actual date will depend on the
security and the nature and extent of services provided to the fund by the fund's custodian.
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The AICPA "Audits of Investment Companies" audit and accounting guide says the
following regarding the accounting for paydowns:
"Because investors in GNMA certificates do not know the exact amounts of monthly
paydowns, amounts are estimated and recorded based on past experience. Subsequent
interest accruals are also calculated based on past experience. Subsequent interest accruals
are also calculated based on estimated remaining principal balances. When amounts of
paydowns are determined, the estimates are adjusted."
d) Interest Adjustments
The monthly principal payment will reduce the security's outstanding principal amount and
the associated interest accruals. During the beginning of the month, the accountant will not
know the amount of principals reductions and resulting adjustment to interest accruals.
Most accounting computer systems will continue to accrue interest at the prior rate, until the
paydown is posted to the system's records. Two basic approaches to making interest
adjustments, or variations on these approaches, are commonly found in actual use.
Daily Interest Adjustments
In order to correct daily interest accruals, the accountant estimates the amount of the daily
interest adjustment and manually enters the adjustment. When the actual paydowns are
posted, the estimates are reversed and the actual interest adjustment posted.
One Time Interest Adjustment
When the daily and cumulative misstatement of interest is not material, a one time interest
adjustment is posted to the accounting records when the actual paydowns are posted.

24.4 Junk Bonds including Step Up Bonds and PIK Bonds

a) Definition
Junk bonds are corporate bonds that carry a high interest rate and are issued in the market by
companies with low or no credit ratings. The term is sometimes more narrowly defined as
high yield bonds that are below 'investment grade' (i.e. Rated below Ba by Moodys or below
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BB by Standard and Poors) and considered ineligible for bank investment under most
commercial regulations.

At first junk bonds were considered to be very risky and as a result activity was limited.
This changed in the mid '70s when it was realised that substantially higher returns could be
achieved than on investments in higher graded securities and that the rate of default on the
bonds was relatively low.
Although 'junk' sounds derogatory, it represents a potentially large market. Potentially over
80% of all U.S. companies could fall into this category if they were to issue bonds, as
financial and other rating requirements of the rating agencies are extremely high.
The advantages for the issuer in issuing junk bonds are:
1. Although a higher rate of interest is paid, it is often lower than that payable for an
alternative source of finance (e.g. bank).
2. They enable the raising of more funds than would normally be available from any other
single source.
3. They facilitate unusual structures and unusual repayment schedules for issuers who say,
may not be able to pay interest for the first few years.
Types of Junk Bonds
Deep Discount securities - Redeemable securities issued at a substantial discount to their
face value at which they are redeemed on maturity. In exchange for the discounted
purchase price, a lower interest rate is paid and so the investor receives low interest
receipts but high accretion credits.
Zero coupon bonds - The extreme form of deep discount securities. These bonds receive
no interest over their lifetime, however, the investor Is compensated by receiving a
significant discount in the purchase price.
Step bonds - These bonds go through different phases or 'steps' in their lifetime with
different interest rates applicable to each step. Most Step bonds step .YQ from (say) a 0%
coupon in the first 8 years to a 13.5% coupon from year 8 to maturity.
Payment in Kind bonds - Instead of interest these bonds accrue and receive additional
principal at fixed payment dates and at fixed accrual rates. The principal received is
added on to the principal held on the books and used to calculate the new accrual for the
next accrual period. At maturity the investor receives the original par amount and the par
value of the accumulated additional bonds receivable.
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The disadvantages for a fund investing in these types of securities are:

Issuer has option to call (step bonds) and decision to pay in cash or in securities (PIK
bonds). Can therefore lose out on future higher yields.
Higher risk = lower credit rated issuers. Ultimate recoverability of principal and
interest.
b) Key Characteristics of Junk Bonds
Zero Coupon Bonds
The main features and concerns with a zero coupon bond are:
As there is no income received over the life of the bond, there can also be no income tax
payable - instead the fund has capital gains and could be subject to capital gains tax,
which in some countries, has a lower applicable tax rate than income tax.
The growth of the zero coupon bond market was helped by the increasing volatility of
interest rates. The bonds were used as a method of eliminating the risks associated with
interest rate movements for both the issuer and the investor.
They are ideally suited for funding long term contracts (e.g. property development) where
the income is only generated at the end of the contract.
The accretion calculation is crucial as it is the only form of income on the security;
therefore, it is important to spread it evenly over the life of the asset (using Straight Line
or Years to Maturity method).
Disadvantages include:
High issue costs as the costs are based on the nominal value of the bond although a lesser
amount of cash will actually have been raised.
Prices tend to be more volatile. This is because of the greater credit risk assumed by the
investor as the borrower is required to pay a relatively large sum at maturity. This means
that the value tends to be more sensitive to changes in the credit status of the borrower.
Step Bonds
A type of high yield debt instrument with deferred interest payments or whose interest rate
resets at specific times during its term. Typically the bond is callable by the issuer.
Example - Company A will issue bond paying 2% interest for first 3 years with interest
payments to be made at end of year 2 and 3. After the 3 year period Company A can "call"
(redeem) the bond. Note that issuers have the option to call. In this example the Bond will

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then earn 8% for next 3 years and 13% for last 3 years. Step bonds are issued mostly by
issuers with low credit quality or issuers with initial cash flow pressures. The short term
interest rate offered will be slightly in excess of short term bond rate. Overall yield to
maturity will be attractive.
The advantage for the issuer is that they have the option to call bonds. They can manipulate
interest rate movements in their own favour, for example if there is a decrease in interest
rates announced they can call the step bonds.
The disadvantage for the issuer is that the yield exceeds that of normal bonds. In the case of
step bonds if the issuer cannot enforce the call the bond can become an expensive form of
finance.
From the investing funds perspective the advantages of investing in step bonds are
Offer higher yields than conventional debt securities (especially if willing to invest over
longer term).
Can earn "accretion of discount" if initial stages at zero coupon. Per US GAAP = realised
and unrealised. May suit requirements of shareholders in fund better.
Accounting
Income on these bonds should be recorded using the interest method:
- I.e. interest income should be accrued evenly based on the latest applicable coupon rate
(no impact by the actual timing of the cash payments). Matching principle.
- Receipt of future rates not probable = can only record based on latest applicable coupon
rate.
- Consider - Notification of rate change.
A common accounting practice is:
Accrue the interest income only for the period of time that interest is due (normally the
latter half of the bond's life). This ensures that the accruals coincide with the receipts.
Accrete the discount on the security over the period of time that the coupon rate is at its
lowest (normally the early stages of the bond's life)
It is important therefore, to ensure that the discount period has been correctly recognised on
the system/master file. It is also important for the fund accountant to monitor any step bonds
so that the date of 'step-up' or 'step-down' of the coupon rate is not missed causing potentially
significant income accrual errors.

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Chapter 25 Derivatives
25.1 Overview of Derivatives
a) Definitions
This chapter is designed to give a broad overview of the most common types of derivatives,
their uses, the sources providing them, how they are accounted for and the current regulatory
environment.
Financial instruments include derivatives.
Financial instruments have been associated with incidents where substantial losses have been
incurred by organisations. As a result there is a perception that financial instruments, and in
particular derivatives, increase risk. Properly used, derivatives are designed to manage
exposure to risk. Many of the high profile incidents that have occurred represent failures of
internal control rather than systemic risk arising from derivates.
A financial instrument is any contract that gives rise to a financial asset of one entity and a
financial liability or equity instrument of another entity. International Accounting Standard
32 Financial Instruments: Presentation (IAS 32).
This definition is similar to those included in (Accounting Standards Board Financial
Reporting Standard 13, paragraph 2) in respect of financial asset, financial liability, and other
instruments.
Per IAS 32 a financial asset is any asset that is a contractual right to receive cash or another
financial asset from another entity, or a contractual right to exchange financial instruments
with another entity under conditions that are potentially favourable, or an equity instrument
of another entity.
A financial liability is any liability that is a contractual obligation to deliver cash or another
financial asset from another entity, or a contractual right to exchange financial instruments
with another entity under conditions that are potentially unfavourable.
An equity instrument is defined as an instrument that evidences an ownership interest in an
equity after deducting all its liabilities.
This has a wider meaning than equity shares because it includes some non-equity share as
well as warrants and options to subscribe for or purchase equity shares in the issuing entity.

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The reference to contract, contractual right and contractual obligation are fundamental
to the definition of a financial instrument, financial asset and financial liability.
Consequently assets and liabilities that are not contractual in nature are not financial assets
or financial liabilities. Hence tax liabilities that arise from statutory requirement imposed by
governments and not from contracts are financial liabilities.
Although a contract must have clear economic consequences that the parties have little, if
any, discretion to avoid and is usually enforceable in law, it does not necessarily need to be
in writing and may take a variety of forms. This financial assets and liabilities may take a
variety of forms.
A derivative is defined in International Accounting Standard 39 Financial Instruments:
Recognition and Measurement (IAS 39).
A financial instrument or other contract with all three of the following characteristics:
-

Its value changes in response to the change in a specified interest rate, financial

instrument price, commodity price, foreign exchange rate, index of prices or rates,
credit rating or credit index, or other variable, provided in the case of a non-financial
variable that the variable is not specific to a party to the contract ;
-

It requires no initial net investment or an initial net investment that is smaller that

would be required for other types of contracts that would be expected to have a similar
response to change in market factors ;
-

It is settled in the future.

Underlying items include equities, bonds, commodities, interest rates, exchange rates and
stock market and other indices.
Derivatives are financial instruments designed to achieve an economic result when an
underlying security, index, interest rate, commodity or other financial instrument moves in
price.
Derivatives financial instruments include futures, options, forward contracts, interest rate
caps, collars and floors, forward rate agreements, commitments to purchase shares or bonds,
not issuance facilities and letters of credit.
On inception derivative financial instruments give one party a contractual right to exchange
financial assets with another party under conditions that are potentially favourable, or
conversely a contractual obligation to make such an exchange under potentially unfavourable
conditions. Some instruments include both a right and an obligation to make an exchange
(e.g. a forward foreign exchange contract).

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Not all derivatives are financial instruments. Any derivative whose terms do not include the
receipt or delivery of financial assets or exchange of financial liabilities is not a financial
instrument.
b) Use of Derivatives
Derivatives are used mainly either for hedging purposes (efficient portfolio management) or
for speculative purposes. Speculative use of derivatives is the use to profit from future
movements in underlying markets.
One of the earliest users of derivatives was the United States where trading in commodities
was popular. Europe was slower to adopt derivatives and they were initially used for risk
management (primarily for interest rate and exchange rate management) due to underlying
economic changes in Europe. This is typified in the UCITS regulations where entry into
derivatives is permitted for efficient portfolio management. Over the last ten or so years,
there has been a rapid development in products to provide solutions to investment
management problems.
Failures have caused regulators to increase regulation for derivatives. Their reviews have
concentrated upon:
disclosure of risks to investors
requiring providers to have risk management policies and procedures
Now derivatives are recognised as a valid investment strategy technique, particularly in the
current environment of unstable equity markets.
c) Derivative Exchanges and Providers
Derivatives are traded on a number of different stock exchanges globally. Derivatives
contracts can also be traded with providers willing to provide specific products to clients,
over the counter.
Over the counter derivative trades are a client specific agreement between an investor and a
broker/counterparty. OTC contracts are priced by the issuer as opposed to the situation with
exchange traded derivatives where the contracts are marked to market.
When comparing exchange traded and OTC derivates contracts we can see below where the
main differences lie:

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Terms of contract
Trading Activity
Exposure to default
Credit Risk Mitigation
Regulation
Valuation
Main Types

OTCs
Negotiable
Bilateral
Counterparty
Optional margin payments
(dependent on contract)
Contract based
Issuer / Price Model
Options, Forwards, Swaps

Exchange Traded
Standardised
Exchange
Exchange Clearing House
Mandatory margin payments
Jurisdictional based
Exchange / Market
Futures, Options on Futures,
Equity Options

There are many stock exchanges worldwide offering derivatives contracts to investors.
Some of the major exchanges offering derivative contracts and settlement facilities to
investors dealing in derivatives are:

Chicago Mercantile Exchange (CME)

Chicago Board of Trade (CBOT)
New York Mercantile Exchange (NYMEX)
New York Board of Trade (NYBOT)
Montreal Exchange (MX)
Toronto Stock Exchange Futures & Options (TSX)
London International Financial Futures & Options Exchange (LIFFE)
The London Metal Exchange (LME)
The European Derivatives Market (EUREX)
Sydney Futures Exchange (SFE)

Hong Kong Futures Exchange (HKFE)

Tokyo International Financial Futures Exchange (TIFFE)
Tokyo Grain Exchange (TGE)
Singapore International Monetary Exchange (SIMEX)
Trading via these exchanges may be through traditional open outcry floor trading or as is
increasingly the case, automated screen based trading.

Clearing Facilities
Clearing facilities have been set up by exchanges to facilitate the trading of derivative
positions. Members of such clearing arrangements must have minimum net worth
requirements. Facilities provided include:
Ensuring the settlement of trades

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Guaranteeing clearing members performance of each contract

Substitution of the clearing house for counterparties to a contract
d) Margining
When trading in derivatives a collective investment scheme will appoint a broker to process,
record and settle derivative trades on its behalf. For exchange traded derivative contracts the
broker will settle trades with the clearer linked to the exchange. In order to ensure the
exchange traded derivatives market functions properly a margin is paid by the party entering
into the derivative contract (initial margin). Initial margin can be in the form of cash or near
cash securities, e.g. US Treasury Bills.

25.2 Futures
a) Definition
A future contract is an example of a type of derivative instrument. For example, a gold
futures contract is a derivative instrument because the value of the futures contract depends
on the value of the gold that underlies the futures contract.
A financial future is a legally binding agreement to buy or sell a standard quantity of a
specific financial instrument at a predetermined future date and at a price agreed between the
parties through open outcry on the floor of an organised exchange.
A futures contract is a transferable agreement to make or accept delivery of a financial
instrument of standardised specification during a specific month in the future at a price
agreed upon at the time the commitment was made. When a futures contract is entered into
to sell securities, it is a short position. Alternatively, entering into a futures contract to
purchase securities is taking a long position.
Characteristics
Contracts must be standardised in order for exchanges to function
Futures may be offset by corresponding purchase or sale prior to maturity
No risk of counterparty default
Price set by market
Future trades are margined
Future trades are marked to market
Leveraged transaction
May be rolled forward
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The standardisation of contracts enables participants to buy and sell them freely on the
exchange where they are traded, with precise knowledge regarding the characteristics of the
contracts being traded. Participants may offset equal numbers of bought and sold contracts
which they hold of the same type and delivery month, and close out a position without the
need for further communication with the counterparties to the original transactions. This
relieves the participant from the need to take or make delivery on the contracts.
There are two main categories of Future Contracts:
- Commodity futures: the underlying good can be anything other than a financial asset.
There are commodity futures on a wide variety of agricultural products such as grains.
There are also commodity futures on precious metals such as gold and silver.
These are binding contracts to deliver or receive a specific amount and type of
commodity at an agreed price at a specified future date. The delivery date, location, and
the quantity and quality of the commodity are specified at the time the contract is struck.
Forward commodity contracts result in the actual delivery of the contract in the condition
and location specified in the contract. Although the market itself may be actively traded
with a large number of contracts, individual contracts may not be sufficiently
interchangeable to be tradable. The major participants of the contracts tend to be end
users and producers/suppliers dealing through brokers. An exception is the gold market
which is very liquid with major centres in London and Zurich.
The contracts deal in physical commodities. They are not traded in standardised terms on
recognised exchanges.

There is no exchange or clearer to guarantee performance.

Substitute counterparty may have to be found to close out a position.

- Financial Futures Contracts: Interest rate futures, Currency futures and Stock Index
futures. Interest rate futures are based on particular types of financial instruments whose
prices are dependent on interest rates.
internationally important currencies.

Currency futures are based on certain

Stock index futures are based upon certain

internationally recognised stock indices.

b) How does Futures Contract Work?

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The purchase or sale of a financial futures contract through the exchange is a commitment to
make or take delivery of a specific financial instrument, or to perform a particular service, at
a predetermined date in the future, for which the price is established at the time of initial
execution. For example, the purchase of a June Treasury bill futures contract commits the
purchaser to buy a U.S. Treasury bill in June at an agreed price. Similarly, the sale of a June
Treasury bill contract commits the vendor to sell a U.S. Treasury bill in June at an agreed
price. Thus, an organisation which has bought and sold a June Treasury bill contract has a
commitment to both buy and sell the U.S. Treasury bill in June. These commitments may
then be offset against one another.
As the market price moves for a particular delivery date, holders of open futures contracts
will see corresponding profits and losses from their holdings. The standard nature of each
futures contract makes such gains and losses easy to measure and monitor; movements are
tracked in terms of minimum price fluctuations allowed by the exchange which are
referred to as ticks and carry a definite value for each contract type. For example, the
price of a LIFFE Eurodollar contract is quoted on an index basis i.e. 100 minus the annual
interest rate of a 3 month time deposit. Each tick represents $25, being interest at a rate of
1/100 of 1% for 3 months on $1,000,000. Hence an increase in the price of a June 3 month
Eurodollar contract from 85.05 to 85.10 (which is in fact equivalent to a fall in interest rates
from 14.95% to 14.90%), represents a change of 5 ticks, each having a value of $25, i.e.
$125 per contract.
A stock index futures contract is an agreement to make or accept a cash payment based upon
the index value at the last trading day of the contract. The party entitled to receive the cash
payment if the index value has increased holds a long position in the index future.
Alternatively, the party required to make the cash payment if the index value has increased
holders a short position in the index future.

c) Future Contract Margins

As mentioned earlier, margins are an Inherent feature of Derivative trading, and future
trading is no different. Before trading a futures contract a prospective trader must deposit
funds with a broker. This is known as the Initial Margin and the amount of margin varies
from contract to contract and may vary from broker to broker. The purpose of margin
payments is to provide a financial safeguard to ensure that traders will perform on their side
of the contract.

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Upon completion of all obligations associated with a trader's futures position, i.e. the futures
expiration date, the initial margin is returned to the trader. The initial margin may be 5% or
less of the underlying commodity's value. The reason for the smallness in the percentage is
that there is another safeguard built into the system in the form of marking-to-market.
This means that the trader must realize any losses in cash on the day they occur, this is
known as the daily variation margin. Any losses will be taken from the initial margin.
However when the funds on deposit reach a certain level called the maintenance margin, the
trader is required to replenish the margin bringing it back to its initial level.
The amount of margin payable by or to the investor is marked to market daily. The daily
movement compared to the initial margin is referred to as the variation margin.
Example
S&P500 futures contract
Initial Margin = $17,500 per contract
Variation Margin = $25 per tick
Tick size = 0.1 or $250 per unit of price
Party A sells 10 contracts to Party B at 1500
Settlement Prices
Day 1 = 1510
Day 2 = 1490
Day 3 = 1480
Party B pays Initial margin of $175,000 (10 contracts @ $17,500 per contract) to Party A.
A (the Seller)
Day 1: (1510 - 1500) x $250 x 10 = $25,000 gain
Day 2: (1490 - 1510) x $250 x 10 = $50,000 loss
Day 3: (1480 - 1490) x $250 x 10 = $25,000 loss
The calculation of and the accounting for the daily variation margin is the same for stock
index futures as it is for financial futures. However, unlike financial futures contracts, if the
contract reaches its expiration date, the transaction involves a cash payment, not the delivery
of securities.

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When broker statements are received they outline the futures trading which enables the
trades recorded by the broker to be reconciled to the funds records and the records per the
investment manager. Reconciliation of open futures positions will have many elements
including:
- Reconcile the open long\short positions
- Reconcile the cash balances with broker
- Reconcile the collateral held with broker e.g. US T Bills
In the majority of cases the contracts are never closed out with the delivery of the underlying
security.
d) Uses of Financial Futures Contracts
The two primary uses of financial futures are for hedging and for trading.
Hedging: to reduce risk of adverse movements in financial rates by taking a position that
offsets the existing or anticipated position in the cash market. Note that hedging using
futures differs from using options as one is 'locked-in' to the rate irrespective of actual rate
movements.
Hedging aims to reduce the risk through adverse movements in financial rates by taking a
position in a financial futures contract that offsets the existing or anticipated position in the
cash market e.g. a merchant bank can attempt to lock-in to a current lending rate for cash that
they know will be available for long term investment in 3 months' time by buying the
appropriate future contract. It is Important to note that if a futures contract is used to hedge a
position, then one is 'locked-in' to a rate no matter which way the actual rate moves. This is
different from hedging using options where protection against adverse movements in rates is
.afforded without eliminating the advantages of favourable movements.
Trading/Speculation: is to seek profits from rises or falls in interest rates or exchange rates
without necessarily having to buy or sell the underlying financial instrument or currency
Trading in financial futures contracts enables organisations or individuals to seek profits
from rises or falls in interest rates or exchange rates without necessarily having to buy or sell
the underlying financial instrument or currency.

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Both hedgers and traders are necessary for the efficient operation of the futures markets as
traders are prepared to assume the risks that hedgers seek to avoid, thus providing the market
with the necessary liquidity.
Note - the above two uses can be applied to most derivatives, funds will generally trade them
to hedge (offset risk) or speculate (try to make money).
e) Pricing Futures
Futures contracts are priced by reference to prices in the cash market. As the contracts are
exchange traded and standardised the contracts are generally priced by reference to an
automatic pricing source such as Bloomberg.
If the futures price and the cash price move out of line arbitrage trading will correct this.
An arbitrageur will buy in the cash market and sell the future (a strategy known as a "cash
and carry"), if futures are expensive to the cash market or sell in the cash market and buy the
future if futures are cheap relative to the market.
The difference between the cash price and the futures price is known as the 'basis'. As the
delivery date for a contract nears, the cash price and the futures price will converge and the
basis will move towards zero. Prior to the delivery date the main factor affecting basis
(assuming that the cash and future are identical) is the prevailing interest rate.
Interest rates will determine whether or not it is cheaper to invest in the cash market (which
requires financing) or in the futures market (where margins only are required).
The fair price of a future can be determined by calculating the theoretical futures price as a
function of the spot price in the cash market and financing costs.
Example
The spot price of gold is US$370 and one year interest rates are 5%. The expected price of
the one year gold futures should be equivalent to the cost of buying spot and holding the gold
for one year. This is US$388.50 [370 + (370 x 5%)]. If the futures price were higher, say
US$400 then one could buy in the cash market and sell in the futures market realising a
profit of $11.50 (400 - 388.50). Conversely, if the futures price was lower, say US$375, one
could sell in the cash market and repurchase in the futures market. The proceeds of the cash
sale could be invested at 5% enabling a profit of US$13.50 to be earned [370 + (370 x 5%) 375].
The example, for simplicity, ignores the cost of margins, transaction and other cost.
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For short term interest rate futures the theoretical futures price is calculated by determining
the "forward rate" for the delivery date of the future using spot market rates.
f) Accounting for Futures

See also examples in Chapter 9.6 Accounting for derivatives

The security\index underlying the future is never recorded on the books of the fund.
Example Accounting Policy for Futures
Initial margin deposits are made upon entering into futures contracts and are generally made
in cash or cash equivalents. Futures contracts .are valued based upon their quoted daily
settlement prices. Changes in the value of open futures contracts are recognised as unrealised
gains or losses on futures contracts until the contracts are terminated, at which time realised
gains and losses are recognised. Unrealised gains or losses on futures contracts are shown on
the Schedule of Investments. The variation margin receivable/payable at the reporting date is
reported as an asset or liability, as applicable, in the Balance Sheet.
Financial Statements Disclosure
Balance Sheet
- Current assets/(liabilities): variation margin receivable/(payable) on futures contracts
- Margin Cash included in cash balance and disclosed in notes
- Unrealised gains and losses included in Investments
Profit and Loss Account
- Realised gain/(loss) on futures contracts
- Movement in unrealised gain/(loss) on futures contracts
Schedule of Investments
- Separate heading for Open Futures Contracts
- Details of each future; including number of contracts comprised, long or short and date of
expiry
- Unrealised gain/(loss) on each individual future
- List of the counterparties
Need to ensure adequate disclosure in the efficient portfolio management note.
Futures represent an off-balance sheet products.

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As such the initial purchase of a future will not result in any profit and loss account effect.
The initial margin is generally recorded in a separate balance sheet cash account. The
subsequent price fluctuations of the futures will cause an effect and appropriate accounting
entries will be necessary.
It should be noted that the variation margin results in unrealised gains and losses. Gains and
losses on futures transactions should be realised only when the futures positions are closed
out. It may be helpful to maintain a separate schedule of all futures positions, which would
monitor the variation margin as well as the cumulative unrealised gain or loss on each
position.
Additionally, note that in many instances a separate cash account is maintained at the futures
broker whereby enough cash is maintained to cover any variation margin payments.
However, marking to market must still be performed if appropriate.
Closing Transactions
As mentioned previously, gains and losses on futures transactions are realised only when the
futures positions are closed out. A futures contract can be closed out in two ways. The first is
by entering into an offsetting position, i.e. entering into a long position after holding a short
position or entering into a short position after holding a long position. A futures contract can
also be closed out by allowing it to reach its expiration or delivery date.
When a futures contract is closed out by entering into an offsetting position, gains or losses
are recognised to the extent they had been unrealised.
g) Risks Associated with Futures Activity
The risk associated with Futures, as with forwards, is based on the contract size, and this is
the amount that should be included as per IFRS 7 (Financial Instruments: Disclosures.
IFRS 7 requires a table setting out the foreign exchange exposure, the interest rate profile
and interest rate exposure for investment funds.
The main types of risk associated with financial futures activity can be classified broadly
into four headings:
Business Risk
There is necessarily a business risk associated with any investment that organisations
make in order to participate in any type of business activity. For example, costs will be
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incurred for stamping operations, training, accommodation, administration and systems

etc.
Benefits gained from participation in the form of trading profits or protection provided
from hedging activities and the income from acting on behalf of customers need to cover
and justify this expenditure.
Market Risk
Users of the market, holding open positions in futures contracts, are always subject to the
risk that prices will change unfavourable and that they will incur losses.
Human and Operational Risk
In any business, there is always the risk that losses may be incurred as a result of human
error, poor communication, and lack of understanding, unauthorised activity (including
fraud), inadequate monitoring or other systems breakdowns. Operations in the financial
futures market are no exception in this respect.
Credit Risks
The credit risk inherent in futures activities fall into two categories.
Firstly there is a risk of non-performance on a contract. This risk is relatively remote where
contracts are traded on a formal exchange but is greater where financial futures deals are
done on behalf of customers or with brokers. Secondly, as with similar markets, there is a
credit risk in respect of funds being placed at margins.

25.3 Options
a) Definition
Options are in many ways the most complex instruments to deal with however, they are not
new. Options on tulip bulbs were generally traded in Amsterdam in the 18th century.
Nonetheless, they do cause a great deal of confusion and in particular it is the one sided
nature of the risk to the instrument which can cause confusion.
An option confers on a buyer the right but not the obligation to buy (call) or sell (put) a
specific quantity of a specific underlying asset or instrument at a fixed price at or before a

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future date at the agreed price. In return for this right the buyer pays to the seller (the writer)
a non-refundable premium.
If a purchased option expires unutilised the whole of the premium is lost and the event for
which it was purchased to reduce or eliminate the risk of price movement is overlooked.
Options can relate to many different types of instruments including equity stock, fixed
interest rate instrument, e.g. gilts or treasury bonds, interest rates themselves, currencies and
other kinds of commodities.

Put: An option relating to the sale of an underlying instrument.

Call: An option relating to the purchase of an underlying instrument.
Strike (or Exercise) Price: The price at which the option may be exercised. The strike
prices and expiration dates of traded options are fixed by the relevant exchange (e.g. LIFFE
or CBOT).
Premium: The amount which is paid by the buyer to the seller (or writer) of the option in
return for the option right.
Expiry date: The date on .which the option ceases to be exercisable.
European options: Options that are exercisable only at the expiry of the option.
American options: Option that is exercisable at any point during its life.
Bermudan options: an option that may be exercised only on specified dates on or before
expiration.
Barrier option: any option with the general characteristic that the underlying security's price
must reach some trigger level before the exercise can occur.
In the money: An option which has intrinsic value. That is, the immediate use of the option
will enable a holder to obtain something of value. For example, the holder of a call option to
buy a U.S. dollar treasury stock at $100 could exercise the option, and if the current market
price is $102, would realise $2. The option is therefore said to be "in the money". Similarly,
if the current market price is $100 then the option is said to be "at the money", and

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conversely if the market price is $98 the option is "out of the money" and does not have any
intrinsic value.
Exchange traded options: Options can be traded on a recognised exchange in standard
amounts e.g. Philadelphia Stock Exchange, Chicago Board Options Exchange and LIFFE in
London. Options may also be traded over the counter (OTC) which is entered into for
example between a bank or other provider and its customer.
Example
The underlying price of a security is 122. The following are the strike prices for a call and a
put option:

Call Option

Put Option

At the Money

122

122

Out of the Money

124

120

In the Money

120

124

The call option is out of the money at the strike price of 124 because a call is a right to buy
and you are buying at 124 when the underlying security is valued at 122. This particular
option is regarded as having no intrinsic value.
Whereas the "in the money" call option of 120 has an intrinsic value of 2 points (122 -120)
because the call option confers a right to buy at 120 when the value of the underlying
security is 122. Note that intrinsic value doesn't equal profit - as the holder of the option has
already paid a premium.
For the put option the strike prices for "in the money" and "out of the money" are 124 and
120 respectively. This is because a put option confers the right to the owner to sell at 124
when the underlying security is valued at 122.
Time Value: The other major component is time value, often referred to in American
terminology as 'extrinsic value'.

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Fair value therefore can be stated as: PREMIUM = INTRINSIC VALUE + EXTRINSIC
VALUE.
Logically the longer the life of an option, the more it must be worth, the longer the term of
an option, the greater the possibility that the anticipated movement in the underlying security
will occur and the option will be exercised.
On or before the exercise date the buyer of an option can make a number of choices:
exercise the option (either buy/seek the underlying stock, Index, currency etc at the strike
price)
let the option lapse (walk away from the option., losing the premium)
sell the option (only possible in some markets)

b) Types of Options
(i) Equity Options
Option contracts are normally on 1,000 shares but from time-to-time the size of an option
contract may be adjusted in order to reflect changes to the capital of the underlying security.
Exchange traded options generally have fixed maturity dates which can run on one of three
expiration cycles:
January/April/July/October
February/May August/November
March/June/September/December
Options usually have a maximum' life of nine months and so at any one time three expiration
months may be available to trade. The actual expiration day is dependent on whether it is an
exchange traded options or an Over-the-Counter (OTC) option.
Exercise prices are fixed according to a set scale but, as with contract sizes, may be adjusted
if there is a change to the capital structure of the company in question. When a new option is
introduced there will normally be both an in the money and an out of the money option
available. As the price of the underlying security rises and falls, new striking prices are
introduced and it is possible to have a large number of striking prices if the underlying
security has been very volatile.
Dividends

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In order to receive dividends, holders of traded call options, must exercise their options.
When a share is marked ex-dividend its price will generally fall by the amount of the
dividend. This is usually not the case with the price of the option since the premium should
already have accounted for the dividend. It is, however, important to know the likely exdividend date and amount.
(ii) Interest Rate Options
These are written on cash instruments such as Treasury securities or futures. The exchange
traded interest rate options are written on the underlying instrument being a T- bill/bond.
OTC options are available on Treasury and Mortgage Backed securities. These are European
style options on a cash settlement basis.
c) Uses of Options
To speculate on the price movements of the underlying security: by investing in an
option, an investor is exposed to the market movements of the underlying security without
having to purchase it.
Cheaper to purchase to the option: from point 1, it is cheaper to invest in the option than it
is to buy the equivalent amount of the underlying good while still being exposed to the same
level of risk associated with the underlying good.
Option volatility: as options are derivatives (i.e., they derive their value from the value of
some underlying security), they provide more price action per dollar of investment than the
underlying security.
Adjust risk and return characteristics: Sophisticated/Institutional Investors use options to
adjust the risk and return characteristics of their entire portfolio.
Transaction costs: due to the lower value of the cost of options, the transaction costs are
lower also. Thus, the investor can obtain the exposure required at a lower dollar cost and
thus, lower transaction costs.
Stock Market Restrictions: using options is a way of avoiding stock market restrictions that
may exist. Regulations might indicate that ownership of 10% of a company must be
reported. Owning the options will give the same exposure but not the same regulatory
requirements.
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Examples of the uses of options include

Example 1: A fund anticipates that it will buy a stock In the future (e.g. may anticipate that
the stock will be admitted to FTSE 100 or Sap 500) and that the price may rise before then.
Action: Buys a call option on the Individual stock.
Example 2: A fund holds portfolio with a large number -of holdings matching) index.
Considers that there will be a decline In the market/index.
Action: Buys put option on the index to protect against decline in overall index value.
Strategies
There are a number of basic trading strategies for trading options, including:
Buying Calls (basic concepts only)
This strategy is used when you have a bull view of the market. The more bullish the more
out of the money options traded. A long call position can give a highly leveraged in a
strongly rising market.
The higher the market rises the more valuable the calls become. Breakeven is the strike price
plus the premium. Every point the stock rises past breakeven is profit.
The loss is limited to the premium paid.
Time works against the buyer of call options; If you are a buyer of calls remember to buy
enough time for the bullish scenario to develop.

d) Pricing Valuation of Options

Valuation of options for recording in Investment Fund financial statements is by reference to
the market value of the options (available from typical valuation sources) for OTC &
Exchange traded.
The value of an option can be estimated using a variety of quantitative techniques based on
the concept of risk neutral pricing and using stochastic calculus. The most basic model is the
Black-Scholes model. More sophisticated models are used to model the volatility smile.

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ABCD

These models are implemented using a variety of numerical techniques. In general, standard
option valuation models depend on the following factors:
the current market price of the underlying security
the strike price of the option, particularly in relation to the current market price of the
underlying (in the money vs. out of the money)
the cost of holding a position in the underlying security, including interest and dividends,
the time to expiration together with any restrictions on when exercise may occur, and
an estimate of the future volatility of the underlying security's price over the life of the
option.
More advanced models can require additional factors, such as an estimate of how
volatility changes over time and for various underlying price levels, or the dynamics of
stochastic interest rates.
e) Accounting and Disclosure

See also examples in Chapter 9.6 Accounting for derivatives

The following disclosures must be made for options:
Balance Sheet
- Current assets/(liabilities): Option premium paid + unrealised gain / loss on options
Profit and loss Account
- Net realised gain/(loss) on options
- Net movement in unrealised gain/(loss) on options
Option Purchases
The purchase price (premium) of a purchased put or call option Is recorded as an asset in an
Investment portfolio. The premiums are generally marked to market at the end of the period.
Example 1
Assume 10 (lots of 100 shares) April 2010 calls on common stock XYZ with a strike price of
$55 are purchased for a premium of $7.00 and a total commission of $300.
1.

Opening purchase

To record trade:
DR Options purchased book value

$7,300

CR Payable - Options purchased

255

$7,300

ABCD

Book value = (10 x 100 shares x $7.00) + $300) = $7,300

To record subsequent settlement of trade:
DR Payable - Options purchased

$7,300

CR Cash
2.

$7,300

Unrealised appreciation/depreciation

The market value of the option changes to $8.00. The following entry is made to record the
appreciation. This entry is usually included in a single entry which records the change in the
investment portfolio market value:
DR Appreciation/depreciation - Options purchased

$700

CR Unrealised gain/loss

$700

Appreciation (10 x 100 shares x $8.00) - $7,300 = $700

Termination of Purchased Option
A purchased option terminates through either sale, expiration or exercise.
1.

Sale

A closing sale transaction is affected by selling an option on the same security with the strike
price and expiration the same as the option previously purchased.
The sale of a purchased option is accounted for in a manner similar to the sale of any other
investment security in the portfolio. A realised gain or loss is recorded for the difference
between the premium paid to purchase the option and the premium received from writing the
closing option.
Example 2
Assume a closing sale of the call options in Example 1 at $9.00 per contract and a total
commission of $250.
The sale will reduce the total unrealised appreciation by the total unrealised appreciation for
the calls i.e. it is a reversing entry of the previously recorded unrealised appreciation.
This entry is usually performed automatically:
DR Unrealised gain/loss

$700
256

ABCD

CR Appreciation/depreciation

Options purchased

$700

To record sale and resulting realised gain:

DR Receivable - Options sold

$8,750

CR Realised G/L options sold

$1,450

CR Options purchased book value

$7,300

Receivable = (10 x 100 shares x $9.00) - $250 = $8,750

Realised gain = $8,750 - $7,300 = $1,450
To record subsequent settlement of trade:
DR Cash $8,750

$8,750

CR Receivable - Options sold

2.

$8,750

Expiration

A purchased option which expires unexercised results in the recording of a realised loss in
the amount of the premium paid to purchase the option. All publicly traded options expire
the Saturday following the third Friday of the expiration month.
Example 3
Assume an expiration of the call options in Example 1.
To record the expiration of the option:
DR Realised GIL options expired

$7,300

CR Options purchased book value

$7,300

The unrealised appreciation/depreciation reversal is the same as Example 2.

3.

Exercise

Upon exercise of a call option, the purchase premium price of the option is added to the
exercise or "strike price" to obtain the aggregate purchase price of the security purchased.
Upon exercise of a put option, the purchase premium ' price of the option is subtracted from
the sale proceeds to obtain the net proceeds used to calculate the realised gain or loss on the
sale of the security.
Example 4
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ABCD

Assume the call options in Example 1 are exercised at an aggregate purchase price of
$55,000 and a total commission of $400.
To record the purchase:
DR Investment in securities

$62,700

CR Options purchased book value

$7,300

CR Payable - Securities purchased

$55,400

Investment in securities = (10 x 100 shares x $55) + $400 + $7,300 = $62,700

Payable = (10 x 100 shares x $55) + 400 = $55,400
To record subsequent settlement of equity purchase:
DR Payable - Securities purchased

$55,400

CR Cash

$55,400

f) Options Written
The selling of options is known as writing or granting a call or put option. The writers reason
for writing options is to earn the premium paid by the option buyer. If the option expires
without being exercised, the writer retains the full amount of premium. Unlike buyers of
calls and puts, the writer has unlimited risk, as if the option is favourable to exercise, the
writer will be forced to either sell (call) or buy (put) the underlying asset he/she has written
the option against. Written options may be either covered or uncovered.
Premiums received from writing put and call options are presented as liabilities in the
balance sheet. The premiums received are marked to market against the current value of the
option written. If the current market value exceeds the premium received, there is an
unrealised loss. If the current market value is less than the premium received, there is an
unrealised gain.
Covered call option
A written call option is covered if the writer of the option owns the underlying security in an
equal amount for which the option is written or owns a call option on the same security as
the call written and the exercise price of the call owned is equal to or less than the exercise
price of the call written. The exercise price of the call option owned may be greater than the
exercise price of the call written if the difference is maintained in cash, Treasury bills or
other high grade short-term debt obligations held in a segregated account by the fund
custodian.

258

ABCD

The writer of a covered call option gives up the right to profit from an increase in the price of
the underlying securities to a point higher than the exercise price for the duration of the
option contracts. The risk of loss from a decrease in the value of the underlying securities
remains with the option writer.
Uncovered call option
The writer of an uncovered call option does not own the securities underlying the option
written, nor the right to acquire such securities to satisfy the obligation of the exercise of the
call written. If the call option is exercised, the option writer must purchase the underlying
securities to fulfil the option contract. Accordingly, an uncovered call writer has the' risk of
loss that the purchase price of the underlying securities may increase above the option
exercise price. However, there is no risk of loss if the price of the securities decreases below
the option exercise price.
Covered put option
A written put option is covered if the writer owns a put option on the same underlying
securities with an exercise date equal to or later than the option written and an exercise price
equal to or greater than the option written or if the writer maintains cash, Treasury bills or
other high grade short-term debt obligations with a value equal to the exercise price in a
segregated account.
Uncovered put option
A written put option is uncovered in the absence of owning an equivalent put option as
outlined above. The put option writer has the risk of loss that the price of the underlying
securities may decline. There is no opportunity ' for profit on the underlying- security
because the option holder will usually not exercise the option if the market price of the
security is above the exercise price of the option.
Termination of Options Written
A written option terminates through expiration, exercise or a closing transaction.
1.

Expiration

Upon expiration of a written option, the option writer records a realised gain in the amount
of the premium received for selling the option.
Example 6
259

ABCD

Assume an expiration of the call options in Example 5.

To record the expiration of the options:
DR Options purchased book value

$5,800

CR Realised G/L options expired

$5,800

The reversal of the unrealised appreciation should also be recorded. The entry to reverse
unrealised appreciation is usually included in a single daily entry which records the change
in the fund market value of options written.
2.

Exercise

o Put option
When a put option is exercised the option writer decreases the cost of the security
purchased by the amount of the premium received.
o Covered call option
When a call option is exercised the writer of a covered call option increases the proceeds
received on the sale of the security by the amount of the premium received in writing the
option. Gain or loss on the transactions is to the extent the premium plus aggregate strike
price exceed the investment in securities covering the option.
o Uncovered call option
When an uncovered call option is exercised, the option writer offsets the cost of the purchase
of the securities delivered to the extent of the option premium received. Gain or loss on the
transaction is to the extent the premium plus the aggregate strike price exceeds the
investment in securities covering the option.

3.

Closing transaction

To affect a closing transaction the writer of the option purchases an offsetting put or call
option of the same security with the strike price and expiration the same as the option
written. A realised gain or loss is recorded for the difference between the premium paid to
purchase the closing option and the premium received on the sale of the option written.

g) Stock Index Options

Stock index options are similar to security options except that, rather than giving the owner
the right to buy or sell a security at a specified price, the holder of a stock index option has
the right to receive an amount of cash equal to the difference between the closing price of the
stock index and the exercise price of the option. The holder of a call option has the right to
260

ABCD

buy from the Options Clearing Corporation the value of a specified stock index at the
stated exercise price. The holder of a put option has the right to "sell" to the Clearing
Corporation the value of a specified stock index at the stated exercise price.
Index options are settled in cash, rather than by delivery of securities. The amount of cash to
be paid or received is determined based on the index multiplier. The multiplier is similar to
the unit of trading for a security option. The multiplier is applied against the difference
between the option exercise price and the current value of the underlying index. Different
indices have different multipliers.
Below is a summary of procedures:
Index Options Purchased
The purchase of stock index options is accounted for In the same manner as the purchase of
security options. Stock index options are also carried as an asset in the investment portfolio
and marked to market.
Termination of purchased index option
A purchased stock index option terminates either through sale, expiration or exercise.
Sale
A closing sale transaction is affected by selling an option of the same index with the same
strike price and expiration as the Index option purchased. The sale of a purchased index
option is accounted for in a manner similar to the sale of a security option.

Expiry
A purchased index option which expires unexercised results in the recording of a realised
loss in the amount of the premium paid to purchase the option.
Exercise
Stock index options are settled based upon the receipt of cash rather than the purchase or sale
of a security. The option writer is obligated to pay the option holder an amount of cash equal
to the difference between the closing level of the underlying index on the exercise date and
the exercise price of the option, multiplied by the appropriate index multiplier (assuming the
option is exercised).
Call option

261

ABCD

The holder of an index call option would exercise the option when the value of the
underlying stock index exceeded the exercise price of the option. The call holder would
record a realised gain for the excess of the current index value over the exercise price,
multiplied by the index multiplier and the number of contracts exercised, less the cost of the
premium paid to purchase the option. Accordingly, the option writer records a realised loss
for the excess of the current value of the index over the option exercise price, multiplied by
the index multiplier and the number of contracts exercised, less the premium received on the
sale of the option.
Put option
The holder of an index put option would exercise the option when the exercise price of the
option exceeded the current value of the underlying stock index. The put holder would
record a realised gain for the excess of the exercise price over the current index value,
multiplied by the index multiplier and the number of contracts exercised, less the cost of the
premium paid to purchase the index. Accordingly, the option writer records a realised loss
for the excess of the option exercise price over the current index value, multiplied by the
index multiplier and the number of contracts exercised, less the premium received on the sale
of the option.
Index Options Written
The sale of stock index options is accounted for primarily in the same manner as the sale of
security options. The premiums received upon the writing of stock index options are also
carried as a liability in the fund's investment portfolio and marked to market in the daily
calculation of the fund's net asset value. If the current market value exceeds the premium
received, there is an unrealised loss. If the current market value is less than the premium
received, there is an unrealised gain.
Covered versus Uncovered Options
Because the exercise of stock index options is settled in cash the writer of a stock index call
option cannot cover the option written because the amount of cash required settling the
exercise cannot be determined in advance. However, as a result of broker requirements, the
writer of a stock index call option may segregate in the portfolio cash, cash equivalents, U.S.
Government securities, high grade short-term debt securities or securities represented in the
underlying index, in an amount equal to the current value of the stock index multiplied by
the index multiplier and the number of contracts written in lieu of segregation. The broker
may require that the "collateral" cash or securities be placed in a separate account at the

262

ABCD

custodian or pledged to the broker. Changes in the current value of the stock index written or
the collateral would result in an increase or decrease in the amounts so segregated or
pledged.
A written stock index option may be terminated through expiration, exercise or a closing
transaction.
Expiration
Expiration of a stock index written results in the recording of a realised gain in the amount of
the premium received on the sale of the option.
Exercise
See exercise of purchased index option above.
Closing transaction
To effect a dosing transaction the writer of the index option purchases an- Index option of the
same index' with the same strike price and expiration as the option written. A realised gain or
loss is recorded for the difference between the closing purchase premium and the premium
received on the original index sale.

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ABCD

25.4 Forwards
a) Definitions
Foreign Exchange Spot Contracts
A foreign currency contract is an agreement to exchange one currency for another at an
agreed rate on value date or maturity date. By far the greatest volumes of transactions are
spot transactions whereby, the agreed exchange rate is the rate at the moment, i.e. the spot
rate. By convention delivery is, In fact, delayed for two business days after trade date. This
allows the parties involved to send the required settlement instructions to foreign bank
accounts.
Example
Company A buys USD 1,000,000 and sells MXN 32,000,000 to Company B on Monday.
On Wednesday Company A will receive USD 1,000,000 into its USD account, and transfer
MXN 32,000,000 to Company B'S account.
Note, that entering into spot transactions does not result in realised gains and losses.
Spot Rates
Distinction is made between direct quotes and indirect quotes:
A direct quote represents the number of units of local currency equivalent to one unit of
foreign currency.
Example
In Mexico the spot exchange rate of MXN 32 = USD 1 is a direct quote.
An indirect quote represents the number of units of foreign currency against one unit of local
currency.
Example
In Mexico the spot exchange rate of USD 0.03125 = MXN 1 is an indirect quote.
Distinction is made between bid and offer rates:
A bid rate is the rate at which a bank buys one currency for another and an offer rate is the
rate at which a bank sells one currency for another. When a dealer quotes a range, he will
quote from the bank's perspective. The first number is the bank's buying rate, i.e. the bid rate
and the second number is its selling rate, i.e. the offer rate.
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ABCD

The difference between the offer and bid rate is called the spread. The spread will fluctuate
in an amount according to:

Volatility of the market

Location
Volume of transactions involving these currencies
The size of the particular transaction
The quality of the customer/counter party

Example
Quoting $/MXN on January 4, 2008: 30.65 - 31.05
Therefore, bank A is willing to buy USD 1 for MXN 30.65 (bid rate) and sell USD 1
for 31".05 (offer rate).
A customer who sold USD 100 to bank A received MXN 3,065. If he wanted to buy back his
USD 100 the same day, he would have had to give MXN 3,105. Bank A would have earned
MXN 40 on these two spot foreign exchange transactions, which represents the spread
between the USD/MXN bid and offer rate on January 4, 2008 (note this example ignores any
commission charged).
b) Forward Foreign Exchange Contracts
Introduction
A forward exchange contract is a binding agreement to trade one currency for another at a
specified future date and at a specified exchange rate. There is some depth to the forward
markets for the major trading currencies, e.g. USD, Sterling, Euro, Swiss franc, etc. at
maturities up to six months but at longer maturities the market is thin and individual
transactions in significant amounts can cause fluctuations in the forward rates. These
contracts are traded on an OTC market in which most major banks participate.
A forward contract exposes the holder to a credit risk.
The standard forward dates are as follows:

Dally for up to 7 days

Weekly for up to 1 month
And at months, 1,2,3,6,9,12
It is not uncommon for a bank to quote odd date forward quotes for the major currencies
transactions, above which, a more competitive quote may be made, (i.e. a smaller spread).

265

ABCD

Example
Company A buys USD 1,000,000 and sells MXN 31,500,000 to Company B on December
31 with value date June 30 (i.e. 6 month forward foreign exchange contract).
How Forward Rates are Derived
Forward rates are a function of two factors:
the spot rate for the currencies in question
the difference in interest rate levels between the two countries of origin of the currencies.
Forward rates are not, as one might think, a function of future expectations about
exchange rates.
The reason for this is that an individual, rather than buying a currency 3 months forward,
could buy the currency spot and then invest the currency proceeds in the interest
environment of the currency's country of origin. If interest rates were identical in both
countries, the forward rate would be expected to match the current spot rate. Because interest
rates are not the same in various countries, a differential arises between spot and forward
called the forward differential.
Forward Rate = Spot Rate (+ Or -) Forward Differential
Forward Differential = Spot Rate X Interest Rate Difference X Portion Of Year
Example
Bank A can earn 13% in the U.K. and 8% in Mexico on comparable short term investments.
The spot buying rate for GBP 1 is MXN 59.90. The forward differential is based on the
difference between Eurocurrency interest rates between the base and quote currency.
The forward differential is calculated as follows:
a) Spot rate

GBP
1

MXN
59.90

b) 3 month interest rate

13%

8%

c) Income after 3 months

d) a + c

1 x 13% x (3/12)
= 0.03250
1.03250

e) Forward exchange rate

1.03250 =
61.098
1 = 61.098/1.03250 = 59.17482
By using the formula:

266

59.90 x 8% (3/12)
= 1.198
61.098

ABCD

Forward differential

= 59.90 x (13% - 8%) x (3/12)

= 0.74875

Forward exchange rate

= 59.90 - 0.74875
= 59.15125

The formula gives a less accurate forward rate than the above calculation due to an
approximation in the forward differential formula. However, in practice the formula is used
for the calculation of a forward rate.
c) Uses of Forward Foreign Exchange Contracts
There are two main reasons to purchase a forward contract:
Hedging
Speculation
From an Investment funds prospective, when investing in foreign securities, the fund wants
to (ideally) make gains from the securities increasing in value. However, when the fund is
valued, it is valued in base currency. Thus, the foreign security is valued with a local price
and then converted back to base currency.
Given that currency markets are 24-hours, even if the local price didn't change (e.g. the
market was closed for a day), the actual base value of the security might still be worth more
or less than it was worth the prior day as the exchange rate would have changed.
To offset this currency gain or loss, the Investment Advisor might decide to hedge against it
by purchasing a forward currency contract which will allow the forward to offset any gains
or losses made by converting the value of the asset back into base currency.
d) Valuation of Forward Foreign Exchange Contracts
Depending on the type of company and valuation policy adopted, open forward contracts
may be valued at either the spot rate at the valuation date or at the current forward exchange
rate for the remaining period of the transaction. The latter method Is preferred as it more
appropriately measures the profit and loss available If transactions had in fact been closed In
the forward excha.nge market at the valuation date. Generally Investment funds will value
their open forward contracts using a forward exchange rate.
Note

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The initial accounting entries for forward foreign exchange contracts are recorded in
memorandum accounts in the general ledger.
The fund might decide to close an open forward with an offsetting forward contract. If the
offsetting contract is entered into with the same broker as the open contract, the
fund/company has a legal right to offset the contracts.
The payable will be relieved on the maturity date of the contract. Note, that if the legal right
of offset does not exist, the second contract would be maintained and revalued until the
maturity date of the contracts. Upon, the maturity dates of the contracts the gain or loss
would be realised.

25.5 Warrants
a) Definitions
Warrants confer on the holder the right, but not the obligation, to purchase (call) or sell (put)
a fixed amount of an underlying asset at a predetermined price (the strike or exercise price)
and at a fixed future date (the expiry or exercise date). They are similar to over the counter
options in many respects, but have the following distinguishing characteristics:
Warrants are issued by a company as opposed to being written by an investor and do not
have a clearing house standing as guarantor to the contract. They are used to raise capital
and at exercise the company receives the exercise price. On exercise of the warrant the
number of shares in issue of the company increases and this can have a diluting effect of
the overall value of the company.
Options, particularly traded options, are generally for a shorter maturity than warrants.
Generally warrants have one to three year exercise periods, although longer periods are
possible:
Options usually grant rights over assets which are currently available.
For example, the exercise of a traded equity call option requires the writer of the option to
purchase existing shares on the open market to satisfy the contract; it does not lead to the
creation of new equity. The exercise of a warrant issued by a company will usually lead to
the creation of new equity capital in that company. Consequently, the existing shareholders
may suffer dilution as a result of the exercise of warrants.

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ABCD

Recently, there has been an increase in the range of warrants available. Many are attached to
Eurobond issues as "sweeteners to persuade Investors to accept low yields on the bonds.
Eurobond warrants can be similar to either European options (exercisable only at one
specific date) or American options (exercisable at any time). They can also have delayed
exercise terms where the investor is prevented from exercising the warrants until a specified
date (a European exercise period followed by a period of American exercise). Investment
banks have issued warrants on stock exchange indices, baskets of equities, currencies and
commodities (e.g. oil).
Warrants are generally traded via a stockbroker similarly to trading shares. Trading is in
dematerialised form, no certificates are involved and instead a fund will receive a
broker/custodian confirmation.
Warrants can be European or American style similar to options.
b) Uses of Warrants
Investors who anticipate an increase in the price of an underlying share, currency or index
can buy a call warrant instead of the underlying share at a fraction of the price. For example
an Investor can either purchase the share of X plc at 100 cent or an X plc 100 cent call
warrant. The warrant gives the investor the right to purchase the X plc share at 100 cent in 12
months time for a price, say, of 25cent (i.e. 25 cent is the cost of the warrant). The warrants
do not need to be held to expiry but can be sold back at any time to either take profits or cut
losses.
The example below discloses how warrants may magnify both the gains and losses of the
underlying share:
Price of underlying share rises:
% change
X plc share
+33%
X plc warrant
+100%

Initial Value

Final Value

100 cent

133 cent

25 cent

50 cent

Price of underlying share rises:

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ABCD

% change
X plc share
-20%
X plc warrant
-40%

Initial Value

Final Value

100 cent

80 cent

25 cent

15 cent

Similarly investors can take advantage of a falling market through put warrants whose value
will appreciate in the same manner when a share price falls.
Note - for the purposes of the above, the methodology used to value the warrants is not
relevant.
Detachable

Detachable equity and debt warrants are the most common type of

warrants

warrant. They are issued as part of a host bond and are detachable
immediately and can be traded in the secondary market as separate
instruments. These warrants entitle the holder to purchase new equity
or debt of the, issuer and act as a "sweetener" to the Investor to reduce
the cost of debt. The cost of debt is reduced because the original
investor in the bond will accept a lower coupon in return for a
separately tradable asset.

Window

Warrants which can be exercised only during a specified period in the

warrants

life of a host bond ("the window").

Harmless

Warrants are issued with a host bond and are exercisable into new

warrants

debt of the Issuer. These warrants are described as harmless because

they will be exercisable only up to the date that the host bond is
callable, allowing the issuer to avoid a permanent increase of the total
debt outstanding. The bond can be callable at the end of or during the
exercise period. In addition, the bond into which the warrant can be
exercised usually carries a lower coupon than the original host bond.
For example a company issues a 5 year 12% bond callable in three
years with warrants which can be exercised in the three year period to
the call date into a new 5 year, 10% bond. The warrants could be
detached and sold to investors who believe that in three years interest
rates will have fallen to below 10%. The issuer has the option to call
the host bond in three years time only if the warrants are exercised.
The issuer can use the proceeds of the warrants to reduce the cost of

270

ABCD

the issue, but the option to call the debt and refinance at the call date
if interest rates have fallen is relinquished.
Wedding

Similar to harmless warrants except that prior to the call date on the

warrants

host bond, the warrant can be exercised only if the host bond is also
surrendered. The concept was introduced because most harmless
warrants were issued with American exercise terms which could result
in an increase in the issuer's outstanding debt for the period from
exercise of warrant to the call date for the host bond.

Puttable

Puttable warrants give the investor the right to put (i.e. sell) the

warrants

warrant back to the issuer at a fixed price enabling the risk to be

limited. They are also known as redeemable warrants.

Income

Income warrants pay interest based on the issue price of the warrant

warrants

up to the date of exercise.

Money Back
warrants

The investor has the option to put the warrants back to the issuer at
either a percentage of, or the full amount of the issue price. The
warrant can be priced higher on issue as the investor has greater
security. The issuer reduces the borrowing cost on the host bond by
having the use of the warrant proceeds interest free until the warrant
is either exercised or put back to the issuer.

Naked
warrants

Such warrants are issued separately and not as part of a bond issue.
Naked warrants can be issued either by Investment banks or by
corporations to reduce the borrowing costs of earlier issues, where the
warrants have an exercise period which corresponds to the call feature
of the earlier issue. For example Company A has an outstanding bond
Issue with a 12% coupon which is to mature in 2005 and is callable
from 2002. Sometime after the bond issue Company A could Issue a
warrant which is exercisable from 2002 into 10% bonds which mature
in 2005. If Interest rates do not fall below 10% Company A has in
effect reduced its borrowing costs by the amounts of the proceeds of
the warrant issue.

Cross currency

Warrants which allow the investor to convert from the original bond

warrants

issue into an issue in a different currency. This type of warrant, also

termed a dual currency warrant, offers investors a hedge against the
risk of currency depreciation.

Covered

Covered warrants are not issued by a corporate as part of a bond or

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ABCD

warrants

equity issue but are usually Issued by an investment bank and grant
the investor the right to purchase equity or debt in a third party. The
investment bank guarantees to the investor that the assets (e.g. shares
of a company or group of different companies, so called "basket
warrants'') will be made available on exercise of the warrants. The
financial standing of the issuer of each warrant is therefore crucial.
The consent of the third party will not necessarily have been obtained.
These instruments are called conversion equity warrants.

Currency/

Currency/interest rate/commodity warrants entitle the holder to

interest rate/

acquire a currency at a fixed rate, a fixed interest security (usually

commodity

government securities) or a specific commodity at a future date. These

warrants

warrants are similar to traded options in that they have standardised

terms (premiums, strike prices and expiry periods) but transactions
are conducted OTC rather than through a recognised exchange. In
addition, they generally have longer periods to expiry than
conventional options.
These warrants have become popular with a number of issues each
month. They are usually issued by investment banks who will hedge
their commitments and there are an increasing range of these
warrants. The profit to the investment banks is the difference between
the proceeds of the issue and the cost of the hedge. Such warrants
may also be callable by the investment bank at a fixed price
("callable, warrants") and may be issued with offsetting put and call
tranches.

Equity index

These warrants are similar to the currency/interest rate commodity

Warrants

warrants above except that they are based on a stock exchange equity
index. Such warrants have been developed for countries where there
is no exchange traded option contracts.

c) Pricing/Valuation of Warrants
The price of a warrant comprises the intrinsic value and the time value. The intrinsic value of
a call warrant is equal to the amount by which the price of the underlying asset exceeds the

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exercise price of the warrant (and vice versa for a put warrant). If this value is less than zero,
i.e. the underlying share price is below the exercise price, the warrant is said to be out of the
money and the intrinsic value is nil.
The time value of a warrant is equal to the price of the warrant less the intrinsic value. The
time value takes into account the following factors:
- Underlying asset price/time to expiry/implied volatility/dividend/interest rate
- Implied volatility represents the likely frequency' and size of price changes of the
underlying asset on which the warrant is based.
Investors buy warrants because of the geared exposure to an increase in the stock price or to
insure against any unanticipated rise in the stock price, they will be implicitly taking a view
on the stock and its future growth prospects. It would, therefore, seem logical to factor into
the evaluation some assumptions about dividends and dividend growth and even about
interest rates.
Brokers will often cite "premium" as one of the criteria in valuing warrants and assessing
their comparative merits. This, confusingly, has nothing to do with option premiums. It is
instead related to the premium that must be paid over the current stock price to acquire stock
via the warrant. The premium is usually expressed as an annual percentage figure. The
equation for calculating the premium is as follows:
Premium = (Warrant Price + Exercise price - 1)
Stock Price
Example
Warrant on ABC costs 20 cent
Exercise price = 1 Euro 50 cent
Share Price of ABC = 1 Euro 10 cent
ABC Premium = (20 + 150) - 1 x 100 = 54.54%
Gearing =

Stock price = 110 = 5.5

Warrant Price
20

Gearing
Gearing is a measure of the relative cash outlays between the purchase of the warrant and the
purchase of the stock.

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Gearing =

Stock price .
Warrant Price

With regard to gearing, some of the observations about traded options will hold good.
Deep out of the money warrants will tend to carry high premiums since the ratio of the
exercise price to the stock price will be high. Warrant prices however will reflect the small
value of a deep out of the money call and gearing will therefore be considerable.
Deep in the money warrants will have high value as a result of their intrinsic value and
gearing will be minimal. Such warrants will only hold a premium if the interest charge from
financing the underlying stock is greater than the dividend foregone by holding the warrant.
The payout formula for a currency call warrant at expiry is as follows:
Call Warrant =

(Exchange rate - Strike price) x Nominal

Exchange Rate

At expiry the holder is paid the difference (if positive) between the exchange rate and the
strike price multiplied by the warrant's nominal value. If the exchange rate is below the strike
price at expiry, the warrant expires worthless.
Example
The investment advisor for a fund believes Sterling will strengthen against the Euro.
Current exchange rate is Eur1.38 = GBP1. The fund invests GBP25,000 in a GBP/Eur call
warrant with a strike price of 1.40, nominal value 10 at a price of 40pence.
Therefore the fund acquires 62,500 warrants at 40 pence.
Assuming that at expiry that GBP/Euro has risen 10% to 1.52 the warrant will be worth:
Call warrant = (1.52 - 1.40) x 10 = 79 pence
1.52
62,500 warrants @ 79 pence = 49,375, an increase of 24,375
Many warrants prices will be exchange quoted as they relate to a related exchange quoted
security and will be available from the usual pricing sources.
d) Markets
UK Domestic
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In the UK stock market warrants have been issued by several companies either as a bonus to
shareholders or following capital restructuring. Settlement is on normal stock exchange
terms.
Eurowarrants
The majority of warrants available to investors are Eurowarrants. These are warrants which
were issued in the Eurobond market mostly as a bond with attached equity warrants. The
warrant becomes immediately detachable on issue and thereafter trade in their own right;,
Companies use this market as a source ' of long term- finance at rates considerably below
those available through normal bond issues.
The majority of these warrants are in bearer form and are held on behalf of holders in
CEDEL or EUROCLEAR the Eurobond clearing and settlement organisations. Eurowarrants
may be denominated in any currency.
ADR Warrants
There are warrants available on ADR (American Depositary, Receipts) securities. These
warrants are dealt and settled in line with the procedures for the underlying ADR's. They are
denominated In US Dollars.
Investment Trust Warrants
These are UK warrants on the shares on investment trusts. This is a small market. Investment
trusts generally trade at a discount to their net asset value, frequently at a significant
discount. This gives the investor a chance to buy a part of an investment portfolio more
cheaply than by buying its component assets. A warrant on an investment trust therefore
gives the opportunity of buying an option on an already leveraged investment. The investor
can profit from a rise in the underlying assets or from a narrowing In the discount to net asset
value.

Index Warrants
There are some warrants Issued by investment banks with the FTSE 100 as the underlying
index. Exercise was with reference, to the futures market. The warrants involved had a five
year maturity.

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Warrants on Gilt Edged Stock

Comparatively few warrants have been issued on gilt edged stocks. Long gilt futures and
options and. short sterling futures and options contracts on LIFFE have tended to be more
popular. The use of the notional gilt and short sterling time deposit option contracts enables
an Investor to model options for the maturity on the yield curve which he wished to trade.
Given the more short term nature of the markets the reduction in costs from constructing an
option strategy in this way seem to outweigh the advantages in having a long dated option on
a particular stock.

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Chapter 26 Swaps
26.1 Introduction
A swap is more a financing technique than a derivative instrument. However, swaps are
often used in conjunction with derivatives. For example a corporation may issue fixed rate
bonds but want floating rate funds. Swaps developed in the 1980s as a tool to enable
companies to vary the terms of their loans and therefore to manage their liabilities more
effectively. Swaps were then used in a similar way to manage assets. Swaps originally
developed, where each party to the swap could access a particular market on comparatively
better terms than the other party. This comparative advantage would then be shared between
parties (and any intermediaries arranging the transaction) to lower their funding costs. The
parties entered the markets where they had the advantage and agreed to exchange (swap)
cash flows. The result gave the parties better terms in their preferred market than if they had
entered it directly.
Most swaps are traded Over the Counter (OTC), tailor-made for the counterparties. Only
the counterparties involved need to know about the detail of the Swap. They are not subject
to any regulations which provide more flexibility in what can be agreed.
Swaps can be negotiated over a longer period than either a futures or options a swap could
be negotiated for expiration in 5 or 7 years time.
Key Characteristics
Swap technically a financing technique, not a derivative instrument; involves an
exchange of cash flows.
Often used in conjunction with derivatives.
OTC Swaps can be as basic or as complex as the Counterparties wish.
Notional contracts No money switches hands all payments are calculated on a notional
amount.
Tailor-made To enter into a swap transaction, one party, must find a counterparty that is
willing to take the opposite side of a transaction. If one party needs a specific maturity or
certain pattern of cash flows it could be difficult to find a willing counterparty.

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ISDA International Swaps and Derivatives Association Inc is an industry organisation

that provides standard documentation for swap agreements and keeps records of swap
activity.

Advantages of Swaps
Privacy
Flexibility in terms of each contract
Longer durations compared to futures and options
No regulations
Disadvantages of Swaps
Need to find a suitable counterparty
No changes can be made without agreement by counterparty
Early termination not possible without agreement by counterparty
Creditworthiness of counterparty must be determined

26.2 Interest Rate Swaps

Definition
Plain vanilla interest rate swaps (also called coupon swaps) occur when the two parties to
the transaction exchange the terms under which they pay interest on their liabilities.
Typically, they will exchange interest paid at a fixed rate for interest paid at a floating rate,
and vice versa. The cash flows are in the same currency and there is no exchange of
principal.
Interest rate swaps developed where borrowers had comparative advantages in different
capital markets. For example one party can raise floating rate funds fairly cheaply but wants
fixed rate funds. The other party finds it easy to raise fixed rate funds, but wants floating rate
funds at the lowest possible cost. Banks are the main source of fixed rate funds as they can
usually obtain the finance more cheaply than corporations. However, banks usually want
floating rate liabilities to match their floating rate assets: (e.g. bank overdrafts etc.).
Companies can often raise floating rate funds as cheaply as banks but want fixed rate funds.
Interest rate swaps exploit, to the advantage of both parties, the fact that investors in fixed
rate debt are often more sensitive to credit ratings than investors in floating rate debt. The
development of the swap market has tended to reduce this differential.

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For example, suppose that borrower P is an AAA rated bank which can raise fixed rate funds
at 10%. However, the bank wants floating rate debt to match its floating rate assets. It can
obtain floating rate funds at 6 month USOR +0.25%. Borrower Q is a BBS rated company
which can raise floating rate funds at 6 month USOR +0.75%. However, Q wants to obtain
fixed rate debt to lock in its interest rate cost, but can only raise fixed rate debt at 11.50%.
The differences are shown below:
Bank P

Company Q

Difference

Cost of issuing fixed rate debt

10%

11.5%

1.50%

Cost of issuing floating rate debt

LIBOR+ 0.25%

LIBOR+0.75%

0.50%

The net saving possible, therefore, is 1% and a typical structure involving an investment
bank acting as intermediary might be as follows;
Bank P will issue a $100 million 10% fixed rate Eurobond. Under the terms of a swap
agreement, P will pay floating rate interest at USOR on the $100 million to an investment
bank and in return receive 10.30% fixed rate interest.
Company Q will raise a $100 million Euroloan from a syndicate of banks and pay
floating rate interest at USOR + 0.75%. Under the terms of a swap agreement, Q will pay
10.40% fixed rate interest to the investment bank and receive floating rate interest at
UBOR.
The saving for each party will be as follows:
Bank P
Payment on fixed rate bond
Receipt from swap agreement
Payment through swap agreement
Effective cost of borrowing
Cost of raising own floating rate
debt
Saving

10%
10.30%
LIBOR
LIBOR
LIBOR

- 0.30%
+ 0.25%
+0.55%

Company Q
Payment on floating rate Euroloan
Receipt from swap agreement
Payment through swap agreement
Effective cost of borrowing
Cost of raising own fixed rate

LIBOR
LIBOR

+0.75%
10.40%
11.15%
11.50%

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ABCD

debt
Saving

0.35%

The intermediary investment bank makes a turn of 0.10% by receiving fixed rate interest at
10.40% and paying on to Bank P 10.30%.

26.3 Currency Swaps

Definition
A currency swap, (or cross currency swap), is a foreign exchange agreement between two
parties to exchange a given amount of one currency for another and, after a specified period
of time, to give back the original amounts swapped.
Unlike interest rate swaps, currency swaps involve the exchange of the principal amount.
Interest payments are not netted (as they are in interest rate swaps) because they are
denominated in different currencies). Further, many currency swaps are traded on organised
exchanges lowering counter-party risk.
Key Characteristics
A currency swap is an agreement between two parties to exchange two different
currencies with an agreement to reverse the exchange at a later date
The exchange of currencies at the inception date of the contract generally takes place at
the current spot rate.
The re-exchange at maturity may take place at the same exchange rate or a specified rate
agreed between the parties.

26.4 Credit Default Swaps

Definition
Credit Default Swaps are one of the more straightforward types of credit derivative, as well
as in recent times becoming one of the more popular and controversial. A Credit Default
Swap (CDS) is a credit derivative between two counterparties, whereby one makes periodic
payments to the other and receives the promise of a payoff if a third party defaults. The
former party receives credit protection and is said to be the buyer while the other party
provides a credit protection and is said to be the seller.
Two parties to the agreement:
- Party 1 pays an agreed periodic coupon for the specified life of the agreement (paying
for the insurance policy)
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- Party 2 makes no payment unless a specified credit event occurs

Specified credit event - includes material default, bankruptcy or debt restructuring for a
specified reference asset.
A CDS is designed to transfer the credit exposure of fixed income products between parties.
The buyer of a credit swap receives credit protection, whereas the seller of the swap
guarantees the credit worthiness of the product. By doing this, the risk of default is
transferred from the holder of the fixed income security to the seller of the swap.
For example, the buyer of a credit swap will be entitled to the par value of the bond by the
seller of the swap, should the bond default in its coupon payments.
Credit default swaps resemble an insurance policy, as they can be used by debt owners to
hedge, or insure against credit events such as a default on a debt obligation. However,
because there is no requirement to actually hold any asset or suffer a loss, credit default
swaps can also be used for speculative purposes.
A credit default swap is effectively insurance, where you don't own the asset being insured.
In case of specified credit event:
Assuming no specified occurrence, at end of agreement:
- No further payments to be made
Benefits to the protection buyer:
- Eliminate or reduce credit risk
- Does not have to own any obligations of the reference entity to enter into the swap
- Can therefore be used to speculate and take a 'short' credit position
Benefits to the protection seller:
- Enables the protection seller to gain a credit exposure to the reference entity, without
having to fund the outright position and any related costs
- Can tailor the position to their required risk/return profile (e.g. 8 year exposure where
only 5 and 10 year maturity bonds are available).
- Can gain exposure to markets/counterparties not otherwise" available (for legal or
other reasons)
- Will receive an income stream from the protection buyer

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Ways to unwind a credit default swap:

- Agree to unwind payment with original counterparty in termination
- Assignment to another counterparty
- Entering into an offsetting transaction

26.5 Total Return Swaps

Definition
Total return swap, or TRS (especially in Europe), or total rate of return swap, or TRORS, is a
contract in which one party receives interest payments on a reference asset, plus any capital
gains and losses over the payment period, while the other receives a specified fixed or
floating cash flow unrelated to the credit worthiness of the reference asset, especially where
the payments are based on the same notional amount. The interest payments are floating
payments and are usually based upon the LIBOR with a spread added according to the
agreement between parties. The reference asset may be any asset, index, or basket of assets.
It is a generic name for any bilateral financial agreement where one counterparty, the total
return payer, pays out the total return of the reference asset and in return receives a fixed or
floating cash flow (from the receiver).
The reference asset of a Total Return Swaps gives an investor the opportunity to access the
total return of a variety of assets. These include equities, bonds, loans, and groups of assets
such as portfolios of shares or even whole indexes (i.e. FTSE, S&P etc).
Total return swaps require no exchange of principal, so these types of securities will have no
impact on the balance sheet. They allow investors to access the economic benefits of asset
ownership without utilising the balance sheet, i.e. no initial outlay of money.
When a new Total Return Swap is created the two counterparties to the swap will agree upon
terms of the Swap. The terms of the swap will include the frequency and timing of the Swaps
reset dates.
The fundamental difference between a Credit Default Swap and a Total Return Swap is the
fact that the Credit Default Swap provides protection against a specific credit event.
The Total Return Swap provides protection against loss of value irrespective of cause.

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26.6 Equity Swaps

Definition
An equity swap is a special type of total return swap, where the underlying asset is a stock, a
basket of stocks, or a stock index. An equity index is a measure of the performance of an
individual stock or a basket of stocks. Common equity indices include the Standard &
Poors 500 Index, the Dow Jones Industrial Average or the Toronto Stock Exchange Index.
An equity swap is a swap where a set of future cash flows are exchanged between two
counterparties. One of these cash flow streams will typically be based on an interest bearing
reference asset. The other will be based on the performance of a share of stock or stock
market index. The two cash flows are usually referred to as legs.
Equity swaps enable entities to enjoy the returns from ownership without actually owning
equity.

26.7 Contract for Difference

Definition
In simple terms a Contract for Difference (CFD) is an agreement between two parties to
exchange, at the close of the contract, the difference between the opening price and the
closing price of the contract, multiplied by the number of shares specified within the
contract.

26.8 Swaptions
Definition
A Swaption is an option grating its owner the right but not the obligation to enter into an
underlying swap. Although options can be traded on a variety of swaps, the term swaption
typically refers to options on interest rate swaps.
In exchange for an Up Front Premium the buyer of a Swaption has the Right to enter into a
Specified Fixed rate Swap transaction at some point in the future. Since this is an Option
contract, the buyer is not obliged to execute the underlying Swap transaction if he feels it
may not be beneficial to do so.
Swaptions exists as both American and European Style options
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- American: exercisable at any point during the option term

- European: exercisable only on the last day of the option term

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Chapter 27 - Taxation
After studying this Chapter, you should be able to:
Discuss the tax advantages of locating a fund in Ireland
Identify the main forms of taxation that can apply to a fund
Describe the meaning of tax transparency with regard to funds
Discuss the main considerations of the EU Taxation Savings Directive

27.1 Introduction
The International Financial Services Centre (IFSC) was established in the Custom House
docks area of Dublin in 1987. When the Irish Government decided to promote the concept of
Dublin's IFSC, they had a number of objectives in mind including job creation, redevelopment of the docks area, and increased tax revenues.
The combination of tax incentives, competitive operating costs, and high quality support
services have allowed these objectives to be realised and Ireland has now become an
important location for the formation of offshore funds and other financial activities.
In 1998, the Government reached agreement with the European Commission to phase out the
special tax concessions offered to help establish the IFSC over the period between 2003 and
2005. As a result, no further IFSC certificates would be approved for new operations after
the end of 2000. From 2003 onwards, the Government introduced two new tax rates for all
companies, inside and outside the IFSC, of 12.5% on trading income and 25% on nontrading income.
The key advantages of locating an offshore fund or other offshore financial activity in Dublin
include:
Zero taxation for certain collective investment schemes;

12.5% tax rate applies to service providers;

High quality service providers and sophisticated accounting, tax, and legal support;
Significant management expertise;
Widespread acceptance as a recognised fund domicile;
Competitive operating costs;
English speaking;

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Access to Ireland's extensive tax treaty network

Membership of EU and OECD; and
Time-zone
As we have seen, different types of fund structures (e.g. unit trusts or corporates, UCITS,
Non-UCITS, etc) are available in Ireland to suit the particular requirements of fund
promoters.

27.2 Taxation of Funds

Irish Domiciled Funds (Investment Undertakings)
Pre-Finance Act 2000
Prior to the Finance Act, 2000 Irish funds were generally categorised as either IFSC funds in
which most Irish residents were not permitted to invest, or domestic funds, which
specifically catered for Irish resident investors (other than those specifically permitted to
invest in the IFSC funds without jeopardizing its tax exempt status). IFSC funds were
generally tax exempt as long as they had no Irish investors (although certain categories of
Irish resident investors were permitted to invest). If an Irish fund had Irish-resident investors
it was liable to tax in Ireland at the standard rate of income tax on its income and gains. It
was also liable to tax on certain unrealised gains, however, investors in the fund should not
be liable to any further Irish taxation. Since the enactment of the Finance Act, 2000, Irish
regulated funds are open to all investors (i.e. both resident and nonresident).
Post Finance Act 2000
The Finance Act came into force in April 2000, creating a new tax regime for all Irish
domiciled funds (whether serviced by IFSC licensed entities or not). In effect, the tax
situation for what were previously IFSC funds and domestic funds is now the same, which
are now specifically known as investment undertakings though often still referred to as Irish
funds (the terms are inter-changeably used below).
As a result of the Finance Act, 2000, Irish funds are now called investment undertakings and
are only subject to tax on chargeable events. Such chargeable events generally speaking only
arise in respect of holdings by Irish resident or ordinarily resident investors.

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ABCD

For the purpose of non-Irish-resident investors and certain categories of Irish investor, the
funds effectively remain the same and may be regarded as tax exempt by such investors.
However, tax can arise on the happening of a "chargeable event" in a fund. A chargeable
event is defined in S.739B of Taxes Consolidation Act 1997 and includes any distribution
payments to unitholders or any encashment, redemption, cancellation, transfer or deemed
disposal (a deemed disposal will occur at the expiration of a relevant period - please see
below for further discussion on the deemed disposal rules of units). No tax will arise on a
fund in respect of chargeable events arising for unitholders who are not resident nor
ordinarily resident in Ireland. This is provided the relevant declaration is in place at the time
of the chargeable event and also provided the fund is not in possession of any information
which would reasonably suggest that the information contained in the declaration is no
longer materially correct.
A chargeable event does not include:
An exchange by a unitholder, effected by way of an arms length bargain where no
payment is made to the unitholder, of units in a fund for other units in the fund;
Any transactions (which might otherwise be a chargeable event) in relation to units held
in a recognised clearing system as designated by order of the Irish Revenue
Commissioners;
A transfer by a unitholder of the entitlement to a Unit where the transfer is between
spouses/civil partners and former spouses/civil partners, subject to certain conditions; or
An exchange of units arising on a qualifying amalgamation or reconstruction (within the
meaning of Section 739H of the Taxes Act) of a fund with another fund.
It should be noted that although this tax is a liability of the fund, it is effectively suffered by
the unitholder out of their investment proceeds. This will be set out typically in the offering
circular of the fund. As such, from a technical perspective, the fund must register for tax, and
may have to pay tax (depending on their investor base, rather than whether they realise a
profit from their own investments activities).
As mentioned above, there are certain categories of Irish-resident investors who can invest in
funds without causing the fund to have any liability to tax as envisaged above.
These categories include pension schemes, life assurance companies, other funds
(investment undertakings), charities and intermediaries acting on behalf of non-Irish resident
investors. These are referred to as exempt Irish investors.

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ABCD

As a result of the new provisions, all investors in funds will be required to complete a
declaration declaring whether they are an exempt Irish Investor or a non-Irish-resident
investor. In the event that a properly completed declaration is not received by the fund (or its
administrator) there will be a presumption that the investor is Irish resident and tax will be
applied in the event that a chargeable event arises in relation to their holding in the fund. The
form of the declaration required to be given by each investor has been prescribed by the
Revenue Commissioners.
Under the current tax regime, each fund has to make a twice yearly tax return to the Revenue
Commissioners in respect of any tax due by the fund. The return will include details of any
chargeable events that arose during the period 1 January - 30 June and 1 July - 31 December
each year together with details of any Irish-resident investors to whom payments were made
during the period. The first return (1 January 30 June) is due to be filed by 30 July while
the second return (1 July 31 December) is due to be filed by 30 January of the following
year. This will necessitate each fund applying for and obtaining a tax registration number,
which would not previously always have been necessary.
The rates of tax which apply to chargeable events are as follows (but please see following
paragraph on the Finance Act 2012):
25% in respect of the payment of distributions (where payments are made annually or at
more frequent intervals) and the unit holder is a company. Where the unit holder is not a
company, the rate of 30% applies.
28% in respect of any other distribution or gain arising to the unitholder on an
encashment, redemption or transfer of Units by a unitholder provided the unit holder is a
company. Where the unit holder is not a company, a rate of 33% applies.
Deemed Disposal Provisions
The deemed disposal provisions referred to above were introduced in the Finance Act 2006
and subsequently amended in Finance Act 2008. The rule relates to an automatic exit tax for
unitholders who are Irish resident or ordinarily resident in Ireland only in respect of units
that are held by them in the fund at the ending of a relevant period.
A relevant period is defined as a period of 8 years beginning with the acquisition of the units
by the unit holder and each subsequent period of 8 years beginning immediately after the
preceding relevant period).

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ABCD

Such unitholders (both companies and individuals) will be deemed to have disposed of their
units (i.e. the deemed disposal) at the expiration of that relevant period, and will be charged
tax at the rate of 25% (where the unitholder is a company) or 33% (where the unitholder is
not a company) on any deemed gain (calculated without the benefit of indexation relief)
accruing to them based on the increased value (if any) of the units since purchase or since the
previous exit tax applied, whichever is later. As above, these rules do not apply to nonresident investors.
Finance Act 2007
The Finance Act 2007 introduced new provisions regarding the taxation of Irish resident
individuals or persons ordinarily resident in Ireland individuals who hold shares in
investment undertakings. The new provisions introduce the concept of a Personal Portfolio
Investment Undertaking (PPIU). Essentially, an investment undertaking (a fund) will be
considered a PPIU in relation to a specific investor where that investor can influence the
selection of some or all of the property held by the investment undertaking.
Depending on an individuals circumstances, an investment undertaking may be considered a
PPIU in relation to some, none or all individual investors i.e. it will only be a PPIU in respect
of those individuals who can "influence" selection. Any gain arising on a chargeable event in
relation to an investment undertaking which is a PPIU in respect of an individual that gave
rise to the chargeable event and occurs on or after 20th February 2007, will be taxed at the
standard rate plus 33 per cent (currently 53%). Specific exemptions apply where the property
invested in has been widely marketed and made available to the public or for non-property
investments entered into by the investment undertaking .
Indirect Tax
Stamp Duty - No stamp duty is payable in Ireland on the issue, transfer, repurchase or
redemption of units in a fund. Where any subscription for or redemption of units is satisfied
by the in specie transfer of securities, property or other types of assets, Irish stamp duty may
arise on the transfer of such assets.
No Irish stamp duty will be payable by a fund on the conveyance or transfer of stock or
marketable securities provided that the stock or marketable securities in question have not
been issued by a company registered in Ireland and provided that the conveyance or transfer
does not relate to any immovable property situated in Ireland or any right over or interest in
such property or to any stocks or marketable securities of a company (other than a company
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ABCD

which is an investment undertaking within the meaning of Section 739B of the Taxes Act)
which is registered in Ireland.
Value Added Tax - There are wide ranging VAT exemptions with regard to the provision of
services to funds (e.g. administration, transfer agency, investment management, etc) and to
the extent that a fund suffers Irish VAT on certain services it receives (e.g. audit and legal
fees) the fund may be in a position to recover this VAT based on its VAT recovery rate. The
recovery rate will be based on either (i) the extent that securities of the fund are invested
outside the EU or (ii) the extent that the investors in the fund are located outside the EU.
Whichever basis is used, it must be applied consistently from one period to the next.
Foreign Domiciled Funds
Whether or not a fund established outside Ireland will be subject to Irish taxation depends on
the application of the Irish tax residence rules. A fund established in the form of a company
will be resident and therefore liable to Irish tax on all of its income and gains if the central
management and control of the company is located in Ireland.
Central management and control is a phrase which has been the subject of much legal
discussion over the years but generally speaking, it means the place where the most
important decisions affecting the company are taken. In other words, if the company had a
mind, the place where the mind is located would be where the central management and
control is located.
Since administrators and custodians will tend to make decisions on behalf of the fund in the
course of their work, there is always the possibility that a non-domiciled Irish fund may be
regarded as resident here and therefore liable to Irish tax. There are a number of steps which
can be taken to avoid the implication that the central management and control of the fund is
located in Ireland. Some of the more common ones are:

ensuring all the directors of the fund are resident outside Ireland;
ensuring all board meetings are held outside Ireland;
ensuring all shareholder meetings are held outside Ireland; and
ensuring all major decisions affecting the fund are fully considered by the board of
directors of the fund and that any action taken to address these issues are based on
decisions made by the board.

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A Unit Trust is regarded as being resident in Ireland for income tax purposes where the
trustee is resident in Ireland or a majority of the trustees (if more than one) are resident in
Ireland. In certain cases, for capital gains tax purposes, the administration of a trust in
Ireland can make the trust resident in Ireland (regardless of the residence of the trustees).
Tax on Assets
Regardless of whether a fund is subject to Irish taxation or not, it will most probably have to
pay tax, in each country in which it has assets, on the profits made or income derived from
those assets. Although most countries do not attempt to levy tax on non-residents directly, it
is common to impose some form of withholding tax on income and less frequently on gains.
Withholding tax is a tax which someone paying money to a non-resident of a particular
country is obliged to deduct from the payment.
Many countries have agreed to enter treaties with each other regulating the taxation by each
country of profits obtained by residents of one country in the other, with the objective of
avoiding tax being charged twice on the same income. For example, Ireland has entered into
double tax treaties with all EU-member states, the United States, Canada, Japan, Korea,
Australia, Switzerland, and a number of others. Most tax treaties may only be relied upon by
individuals and companies who are actually subject to tax in the other country. Therefore, as
a result of the taxation treatment of Irish funds (i.e. no tax at the fund level per se) the
question of treaty access for Irish funds is not clear-cut and needs to be considered on a
treaty by treaty basis.

27.3 Taxation of Investors

As you will have seen above, non-Irish resident nor ordinarily resident investors in an Irish
fund are not subject to tax in Ireland on their investment in the fund provided that a relevant
declaration is in place and the fund is not in possession of any information which would
reasonably suggest that the information contained therein is no longer materially correct.
Nevertheless, such investors may be subject to tax in their home country on income or gains
derived from holdings in an Irish fund.

Offshore Funds

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One of the attractions of an offshore fund, for many investors, is that it enables them to
reduce or eliminate the tax they would pay if they were to make a similar investment in an
onshore fund (a fund domiciled in and paying tax in the country in which the investor is
resident).
Many countries operate anti-avoidance rules designed to prevent their residents and nationals
using offshore funds to avoid paying tax in that country. For example, the UK whose
upper rate of income tax is currently 50% but whose upper rate of capital gains tax is only
currently 28% - currently has provisions in its tax code to treat capital gains realised by an
investor on an investment in an offshore fund by a UK-resident investor as subject to income
tax, unless the fund has obtained what is known as reporting fund status. To obtain reporting
fund status each share class in the offshore fund must register with HMRC prior to the year
end for which it wants to start being a reporting fund. As a reporting fund the offshore fund
must calculate the income arising inside it on a per unit basis each year (using specified UK
tax rules) and notify each investor who holds shares at the funds year end of this number.
This amount per unit (once a deduction has been taken for actual distributions paid by the
fund in respect of the period) is then become taxable in the hands of the investor as income
even though they will not have received it in cash from the offshore fund. However, this
enables capital gains tax to be paid on sale of the investment.
Incidentally, Ireland operates similar non-avoidance legislation for Irish resident investors
investing in non-resident Irish funds however, this is generally only relevant for funds
located in jurisdictions which are not (i) EU Member States, (ii) EEA Member States, or (iii)
OECD Members States, the governments of which have entered into a double tax treaty with
Ireland.
Limited Partnerships
One of the most important aspects of a limited partnership is that many taxation systems treat
the partners as receiving the income and benefits of ownership of their share of the
partnership which is attributable directly to their proportional share of the assets of the
partnership. In other words, the existence of the partnership is ignored completely for tax
purposes. This has the advantage that the investor can use the benefit of the tax treaty
between his own country of residence and the country where the partnerships assets are
located, whereas the partnership itself as a tax-exempt vehicle cannot be able to claim the
benefit of the treaty between Ireland and the country where the partnership has invested.

27.4 The EU Taxation Savings Directive

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The EU Taxation Savings Directive (Council Directive 2003/48/EC) was adopted on 3 June
2003. The objective of the directive is to counter tax evasion on cross-border payments of
savings income by ensuring that EU-resident individuals are taxed in accordance with
domestic laws. The directive applies from 1 July 2005. The directive provides a choice for
member states to opt either to withhold tax or to exchange information in relation to interest
income distributed by a fund. The option to withhold tax is a transitional arrangement and
has been opted for by Luxembourg, Belgium, and Austria. Interest income includes
distributions by a fund where the fund has invested greater than 15% of its assets in debt
securities. Interest income also includes income realised upon the sale, refund, and/or
redemption of fund units/shares where the fund has invested (directly/indirectly) greater than
40% of its assets in debt claims.
It should be noted that the imposition of exchange of information and/or withholding tax on
payments made to certain individuals and residual entities resident in an EU Member State
also applies to those resident or located in any of the following countries; Anguilla, Aruba,
British Virgin Islands, Cayman Island, Guernsey, Isle of Man, Jersey, Montserrat,
Netherlands Antilles and Turks and Caicos Islands. Furthermore, the following countries,
Andorra, Liechtenstein, Monaco, San Marino and Switzerland, will not be participating in
automatic exchange of information. To the extent that they will exchange information it will
be on a request basis only. Their participation is confined to imposing a withholding tax.
The directive applies to paying agents that are defined as any economic operator who pays
interest to or secures the payment of interest for the immediate benefit of the beneficial
owner. In a chain of economic operators, it is the last operator in the chain that is deemed to
be the paying agent. This is in order to prevent multiple reporting. For payments to come
within the scope of the directive, they must be made by a paying agent of one Member State
to an individual resident [or a "residual entity" established, in another Member State (or in
certain circumstances the same Member State of the unitholder] in another Member State. In
Ireland, the paying agent is responsible for reporting payments to the Irish Revenue
Commissioners.
The following is the minimum information which needs to be exchanged under the directive:

Identity of beneficiary (including tax identification number);

Residence of beneficiary;
Account number of beneficiary;
Name and address of paying agent; and
Information on the amount of the interest payment.
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In relation to the exchange of information, the paying agent has to option to exchange either:
The full amount of the distribution / redemption; or
The interest element of the distribution / redemption
In relation to the identification of the beneficial owner the identity tests performed will be
similar to those used for anti-money-laundering purposes.
The directive is currently under review and amending proposals to the directive were
adopted by the Commission on the 13th November 2008.

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