A Better Grasp of Non-financial Risks

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

2. The Rise of Non-financial Risks in the Fund Industry

eligible may well have strengthened the risk management requirements made of fund management firms—including the definition of a programme of activities specific to the instruments dealt with—but the regulators’ failure, until very recently, to take into account post-market problems means that the European framework does not spell out for the depositary the custodial obligations and responsibilities associated with these instruments. In UCITS directives (see article 9 of UCITS III and article 22 of UCITS II): “The assets of a common fund shall be entrusted to a depositary for safe-keeping” and “a depositary shall, in accordance with the national law of the State in which the management company's registered office is situated, be liable to the management company and the unit-holders for any loss suffered by themas a result of its unjustifiable failure to perform its obligations or its improper performance of them” (EC 2008). To decide whether depositaries have performed their obligations properly is, of course, difficult. After all, bookkeeping and depositary obligations were left rather undefined in UCITS. Bookkeeping of assets not safe-kept is associated with the verification of the rights to the assets. Responsibility for verification lies first with the investment firm (as it initiates the purchase of assets that cannot be safe-kept) and then with depositaries. The UCITS directive dictates the organisation that investment firms must have to perform adequate verifications and risk management, but specifies that (UCITS III directive, article 5f) it is the “Member State [that] shall draw up rules of conduct which management companies […] shall observe at all times" (EC 2008). The verifications that depositaries must

perform, however, have not been defined in European law.

The unclear liabilities of depositaries are a major stumbling block, because it is hard for depositaries to know the extent to which they need to perform due diligence and exercise oversight and because it is hard for them to charge investment firms for additional verifications not clearly expressed in regulations. Depositaries cannot check every investment made by the asset manager, so it is hard for them to meet the letter of their obligation to exercise checks over the entire portfolio. The possible incompleteness of ex post partial controls has always been a problem; in fact, there is an inherent conflict between the depositary’s obligation to monitor the decisions made by asset managers and the need to allow swift implementation of investment decisions. In practice, then, most monitoring takes place after the fact. So what is the appropriate time-frame for verifications? How exhaustive should they be? How to split the liability for losses between the asset managers and the depositary? Too often, these questions have not been posed. For all the checks that cannot be automated, depositaries sometimes choose a sample of the transactions completed by asset managers and check compliance. UCITS regulations requires that target funds comply with quantitative restrictions: article 19 (EC 2008) requires that target funds be “authorised under laws which provide that they are subject to supervision considered by the UCITS' competent authorities to be equivalent to that laid down in Community law” and that “protection for unit-holders in the other collective investment undertakings [be] equivalent

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An EDHEC-Risk Publication