A Better Grasp of Non-financial Risks

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

1. Large Non-financial Risks in Retail Funds Finally Make a Mark on the Regulatory Agenda

be a useful means of eliciting their views on necessary regulatory changes and on risk management practices.

risks by a limitation of conflicts of interests (notably by disclosures). The preparatory green paper (EU 2005) shows that regulators were not unaware of potential risks: “the Commission feels that, with its reliance on formal investment limits, UCITS may struggle in the longer term to keep pace with financial innovation”. UCITS (undertakings for collective investment in transferable securities) is the set of European directives that allow retail collective investment schemes to operate freely throughout the EU on the basis of a single authorisation from one member state. UCITS may designate a coordinated retail investment fund subject to the UCITS directive. This recognition, however, is part of the general statement and not of the sections regarding law improvements, probably because at the time the Commission stated: “From an investor protection perspective, there have not been notable financial scandals involving UCITS. UCITS has provided a solid underpinning for a well-regulated fund industry”. Likewise, the Commission acknowledged that a single market for depositary services would first necessitate “further harmonisation of the status, mission and responsibilities of these actors”, but only as part of the long-term challenges of the industry, not of any concrete proposal. In addition, the eligible assets directive (EAD) has no reference to the non-financial risks or post-market difficulties that could be generated by the enlargement in eligible assets; CESR (2007) has issued level-3 guidelines for the definition of eligible assets but no guidelines for depositaries and post-market operations. In none of these texts is sub-custody mentioned.

1.2 EU Regulatory Authorities and the Industry Failed to Take Non-financial Risks into Account EU regulators and the fund industry have failed to make adequate allowances for the operational consequences of financial innovation and for changes to funds. Progress has been made, to be sure, above all in governance, but, on the whole, provisions for managing non-financial risks, as well as the means of managing them, are still unsatisfactory in the UCITS framework. Governance was improved and operational risks on transactions made with central counterparties (CCPs) were given more attention. On the whole, however, transactions outside CCPs were neglected. 3 Corporate law has accorded governance greater importance. The European Commission, however, has failed to guarantee the security of the settlement, custody, and control of operations performed outside the traditional space of securities held by central security depositaries; it is of course outside this space that the main realistic non-financial risks in investment funds arise. This failure is apparent in the European green and white papers (EU 2005, 2006) on enhancing the EU framework for investment funds, since the objective of white papers is to make concrete proposals to be discussed before laws are drafted. The green and white papers dealt mainly with simplifications in procedures; some attention was given to the prevention of

3 - The growing importance of governance has been reflected, in part, in UCITS regulations. Investment firms that manage UCITS are subject to organisational and risk management requirements (III.C-5f) whose aim is to limit conflicts of interest and control risks. Organisational and risk management requirements have also been designed by the CPSS-IOSCO for central counterparties (BIS 2001) and for central securities depositories (BIS 2010). MiFID encouraged broker-dealers to compete with each other. The crisis has led IOSCO to focus again on market infrastructure; IOSCO made recommendations for CCPs for derivatives (BIS 2010)

Without improvements to EU regulations, non-financial risks increased as funds relied

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An EDHEC-Risk Institute Publication