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

and of European recommendations was facilitated because the loopholes in EU laws (such as the failure to spell out the duties associated with bookkeeping and with the sub-custody of assets) mean that country regulators are left to define—or not to define—these duties and because the outcome of level 3 of the European Lamfalussy process (supervisory committees facilitating the convergence of regulatory outcomes) is not binding and is not part of Community law and it is not mandatory to take EU implementations. Various definitions of eligible assets Article 19(1) of the UCITS directive defined eligible assets (in the main, transferable securities, units of other investment funds, deposits and money-market instruments, and financial derivative instruments) as well as the quantitative restrictions that can be interpreted as diversification requirements. As the examples below will show, the UCITS directive gives countries leeway in the choice of authorised instruments and techniques. The definition of eligible assets in the UCITS regulation is sometimes vague. Ireland, for its part, has defined more precisely the recently issued transferable securities (UCITS, 19.1.d) and limited holdings of them to 10%. 9 The French regulator (Monetary and Financial Code, article R. 214-1-1) has defined a list of eligible assets; other countries have not. According to article 19, UCITS can invest in “units of UCITS authorised according to this Directive and/or other collective investment undertakings within the meaning of the first and second indent of article 1(2), should they be situated in a Member State or not”. In such countries as France, target funds must be UCITS, whereas

in others, such as Luxembourg, they must be equivalent to UCITS.

A more widely discussed issue has been that, although UCITS regulation stipulates that (article 19.2.d) “a UCITS may not acquire either precious metals or certificates representing them”, this clause has not been transposed equally in all countries. France has been the most faithful to the UCITS directive, and thus the most restrictive, by forbidding investments in precious metals. Luxembourg and the UK have allowed investments in gold bullion securities (as long as there is no physical delivery, in compliance with the UCITS requirement for derivatives on commodities), and the UK has allowed investments in other precious metals; Ireland has not transposed article 19.2.d at all, and thus authorises investments in securities with precious metals as the underlying asset. These differences are disappearing with the development of exchange-traded funds (ETFs) on precious metals. After all, ETFs are listed regulated funds and as such are usually eligible for UCITS, even when they have precious metals as underlying assets. In addition, although UCITS allows temporary borrowings of amounts less than 10% of the NAV of the fund, which can be seen as an impediment to short selling (naked short sales are forbidden), country regulations (see article R. 214-12 of the French Monetary and Financial Code) sometimes allow temporary acquisition or sale of assets (in other words, repurchase agreements) for up to 100% of the NAV of a fund. In practice, then, traditional forms of short selling are possible even without recourse to derivatives, which, because they hide the true nature of transactions, make it possible to get around

9 - There are also slightly different definitions of authorised deposits and money-market instruments. 10 - This practice is, however, seldom used in French UCITS because prime brokers are entrusted with the custody of some assets, yet the depositary retains full responsibility for restitution.

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An EDHEC-Risk Institute Publication