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

The liquidators of Luxalpha have taken legal action against the Luxembourg regulator (LePage 2009).

This failure to return assets of a UCITS raised awareness of the diverging obligations of depositaries in Europe and the notion that they are greater in France than in most other countries in Europe. The enforcement of regulations in France and Luxembourg differs too. The French Monetary Authority has direct powers of enforcement, but the CSSF, the Luxembourg regulator does not: if the client refers a case to the regulatory authority, the financial institution is not bound by the CSSF’s decision. In the resolution of disputes between professionals under its supervision “the opinions it issues are not binding” (CSSF 2007, 160). When assessing the responsibility of the depositary in the Lehman case, the French supervisor imposed a strict liability on the depositaries of funds in a strict interpretation of a law that was very protective of investors. When assessing the Luxalpha case, the Luxembourg supervisory authorities have pointed towards inadequate due diligence by UBS Securities but have not taken a public position on the obligation of restitution of UBS, a move that was interpreted as business-friendly. The Madoff case also illustrates insufficient supervision by boards of directors of corporate-form investment funds. After all, Gregoriou and Lhabitant (2009) showed that an analysis of the Madoff funds revealed inconsistencies or “a riot of red flags”, which suggests that the board of directors did not aim at best practices in the management of non-financial risks and failed to exercise effective oversight.

4 - In the traditional alternative investment

landscape, investment funds use prime brokers for such services as execution of transactions and clearing of derivatives, producing consolidated risk and P&L reports, providing cash, and securities lending.

1.4 Lehman: Large Sub-custodians Can Default

hedge funds it held in custody; it affected primarily equity long/short funds, regulated or not, that used the prime broker as a sub-custodian: borrowing securities from a prime broker 4 generally involves posting more collateral than the amounts borrowed and the right for the prime broker to rehypothecate (or reuse) 120% of the value of the loan made to the fund. Assets held in sub-custody are kept in a segregated account at the prime broker, and reused assets fall in the prime broker’s general account, from which they usually disappear since they are lent to other investment firms or hedge funds for covering short sales. In addition, country-regulated funds (ARIA EL funds, for instance) usually had

Lehman Brothers was a prestigious institution subject to banking regulations; it benefited from the highest rating and was probably considered immune to the risk of bankruptcy. When it did go bankrupt, however, the assets of some investment funds disappeared and there were long delays in returning other assets. Furthermore, the bankruptcy was the result not of fraud but of a banking and liquidity crisis. Its failure highlighted the pervasiveness of sub-custody risk.

The demise of Lehman as a prime broker meant a failure to return the assets of

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An EDHEC-Risk Publication