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

more heavily on leverage, on derivatives, and on investment in target funds and in countries that required local sub-custody.

and allowed custody by securities firms, facilitated fraudulent practices such as the creation of Ponzi schemes. In Europe, for the first time, some UCITS funds—UCITS are the European coordinated regulated funds, i.e. , the counterpart to US mutual funds—lost the bulk of their assets as a consequence of the Madoff fraud, the kind of massive losses previously thought possible only at hedge funds. Luxalpha, a European feeder fund to Madoff, had been certified as a UCITS by the Luxembourg regulator, the CSSF, and was thus directly available to retail investors. The failure of the depositary of the fund to return the assets that disappeared in sub-custody means that protection offered by UCITS depositaries is subject to legal interpretations and varies widely within Europe. In reality, then, UCITS is not a European brand; it is country specific. This uneven protection raised immediate concerns, and politicians agreed on an agenda focused on a better definition and a strengthening of depositaries’ responsibilities.

1.3 Madoff Shows That UCITS Can Lose It All Even though UCITS funds as retail products supposedly involve the highest degree of investor protection, Madoff showed that a massive fraud made possible the disappearance of all assets in a UCITS, and this without supervisory authorities or any of the parties involved in the security of unit-holders (the investment firm, the board of directors, the depositary) guaranteeing the security of the UCITS fund or making good on the losses. The Madoff fraud showed the loopholes and inconsistencies in regulation both in the United States and in Europe, as well as the misconduct of some parties. Regulation in the United States, which until the recent Obama package did not require advisors of hedge funds to register with the SEC

Box 1: The Madoff affair Luxalpha, a fund that fed Madoff, should not have won approval as a UCITS because delegating core functions is forbidden in UCITS. UBS Asset Management in fact delegated the management of Luxalpha to Madoff and gave Bernard Madoff Investment Securities (BMIS) sub-custody of all its assets without mentioning this sub-custody in the prospectus. UBS Securities did exempt itself from its responsibility to return the assets but only mentions (Luxalpha 2008) that “The rights and duties of the Custodian pursuant to article 34 of the law of December 20, 2002, have been assumed by UBS Luxembourg S.A., pursuant to a Custodian and Paying Agency Agreement dated August 1, 2006, concluded between the Fund and the Custodian Bank”. That exemption is, however, incompatible with UCITS regulations (UCITS III, art. 7): “A depositary's liability […] shall not be affected by the fact that it has entrusted to a third party all or some of the assets in its safe-keeping” (EC 2008). Furthermore, Madoff was at the end of the day the manager and custodian of his own funds, which is also forbidden by UCITS. The certification of a fund incompatible with UCITS regulation, certification done to comply with requests from UBS clients to access Madoff, illustrates the so-called business-friendliness of Luxembourg.

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An EDHEC-Risk Publication