A Better Grasp of Non-financial Risks

The European Fund Management Industry Needs a Better Grasp of Non-financial Risks — December 2010

Executive Summary

in higher funding costs for investment funds. EDHEC argues that an alternative means of managing counterparty risk would involve relying on tri-party collateral agreements and over-collateralisation with less liquid instruments. Tri-party arrangements would make it possible to shed counterparty risk and avoid the funding cost of posting cash or liquid instruments as margins (equities could then be posted as collateral). Another question is whether regulations have limited the development of risk management techniques. Arguably, they have not helped asset managers adopt best practices for liquidity risk management: by certifying funds invested in potentially illiquid assets as liquid UCITS funds, sometimes even as very liquid money market funds, regulators gave investors a false sense of security. Funds that invest in assets that may become illiquid face the risk of high redemptions, which could lead to fire-sales of their assets; for most illiquid assets, redemptions may simply be impossible. Distributors and management firms, which relied on such certifications, were also deceived. Regulatory bodies would also be well advised to seek alternative regulated vehicles to structure funds with illiquid assets: closed-end funds, which would require a stronger governance framework, are a possible means of isolating and distributing illiquid strategies. The fund industry could also use liquidity risk management techniques, examples of which can be found in the literature on the risk management of hedge funds (De Souza and Smirnov 2004). The assumption that investors will redeem if their capital is insufficiently protected makes the case for a dynamic strategy inspired by constant proportion portfolio insurance. Last, managing sub-custody

risk is important for the protection of investors.

Reducing European regulatory arbitrage. We conclude that homogenisation of country regulations and of supervisory cultures is necessary to prevent regulatory arbitrage: now that the differences in the depositary liabilities are better understood, the costs of depositary services in different European countries could soon diverge and regulatory arbitrage could gain importance, as investment firms could choose their home countries for no other reason than to reduce their costs, perhaps to the detriment of investor protection. The European Securities and Markets Authority (ESMA) will contribute to harmonisation, but the European regulations themselves (level 1 and level 2) should be reworked to ensure “better regulation”, to use a term popularised by the European Commission. Despite the great historical discrepancies in the regulation of funds, convergence is possible. After all, there are elements of convergence; fiduciary duties were once typical of common laws; fiduciary duties for depositaries, asset managers and distributors are now also defined in all European countries because UCITS and MiFID make such provisions; in the British principle-based regulatory environment, depositaries would like more detailed regulatory guidelines and assessment of the responsibility of each party; in the French rule-based regulatory environment, depositaries demand a more principle- based regulation that acknowledges that depositaries cannot be held responsible for what they cannot control. On the whole, a practical definition of depositary duties as well as adequate disclosure of information on non-financial risks to unit-holders is needed. Ideally,

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An EDHEC-Risk Institute Publication