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

an independent depositary or custodian, 5 yet a widespread practice was to have all the fund’s assets safe-kept at the prime broker. The Lehman bankruptcy involved a legal issue: the legal treatment of assets held as collateral at the prime broker, even when segregated, was different in France from what it was in the United Kingdom. The French regulator required that collateral, minus the debt of the investment funds to Lehman, be returned immediately to the investment fund; the UK liquidator blocked the restitution of assets held as collateral, probably on the grounds that this collateral was not free of debt (the borrowings from investment funds). As a consequence, many investment funds could not complete any transactions, and the French regulator ordered depositaries to return the value of the assets to the investment fund. Investment funds lost the cash margins left at Lehman because, even if the cash was posted to be used as collateral, all cash deposits at institutions bear credit risk and disappear when the counterparty goes bankrupt. In addition, asset management firms and depositaries did not meet their obligation to ensure that Lehman did not rehypothecate more than the contractual 120% or 140% limit. Finally, at the time of bankruptcy, Lehman had failed to effectively segregate clients’ assets, as indicated by Justice Michael Briggs in London (Fortado 2010). The practice of rehypothecation naturally limits the effectiveness of segregation and the ability to return assets lent to other firms immediately (prime brokers usually did not commit to immediate restitution).

An important lesson is that even well-regulated and reputed institutions, such as those that act as sub-custodians, may go bankrupt during market crises and that it may be impossible for depositaries to return assets with short delays. In France, where depositaries had an immediate and unconditional obligation of restitution, depositaries had to compensate investors in some ARIA EL funds for assets that had been posted as collateral to Lehman, but the order of 23 October 2008 and the decree of 24 July 2009 allow a depositary’s liabilities to be contractually lowered for OPCVM ARIA and OPCVM contractuel (which use the prime broker to borrow assets). 1.5 Previous Losses Had Already Pointed to Non-financial Risks The Madoff fraud and the bankruptcy of Lehman Brothers are the two recent cases that, more than any other, underlined that non-financial losses can be very large in investment funds and showed up the failings of the regulation of non-financial risks in investment funds. These events echo in a magnified way other heavy operational losses of the last ten years. Until recently, however, the comfort zone of regulatory bodies, politicians, investors, and the entire industry had not been breached, and no clear action was taken. Some historical losses are summarised below (see also figure 4 in appendix 1 for a synthesis). The demise of AIG and Lehman as counterparties for derivatives The demise of Lehman and of AIG led to systemic risk, because all investors who used derivatives as a hedge found their hedges torn up after the bankruptcy: they were suddenly unprotected. Pension funds that hedged their long-term interest rate

5 - The definition of depositary and custodian may differ across countries. In France, the depositary (in charge of controls and safe-keeping) usually does the safe-keeping, too, thus acts as a custodian, a term rarely used. In the US, there is no depositary, as the board of directors is in charge of monitoring; there, a custodian does the safe-keeping. In the UK, the two functions may be distinct. The depositary

is in charge of controls and accounting while the custodian does the safe-keeping.

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