A Better Grasp of Non-financial Risks

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

3. Risks and Responsibilities in the Fund Industry

European regulation seems, then, to draw on the notion that, as the depositary (the bank) is the most highly regulated party, it can act as auxiliary to the supervisory authorities, and as such take responsibility for failures to monitor enforcement of the rules. The application of this notion has spurred debate in common-law countries as well as in countries (Ireland and Luxembourg, for example) in which regulations draw heavily on corporate law and accord great importance to the role of the board. 3.3 The Failure to Define the Bookkeeping Function Although European regulations have assigned the depositary a central role in the protection of unit-holders, the failure to define what exactly “its unjustifiable failure to perform its obligations” (EC 2008) means that assessing the depositary’s liability is difficult. Bookkeeping is defined clearly in such countries as France (book III of AMF general regulation), but it has not been defined Europe-wide. The UCITS directive requires that depositaries check that all transactions made by investment funds comply with regulation and do not violate the terms laid out in the prospectus, but because of the heightened difficulty of monitoring investments in derivatives, structured products, and target funds exhaustive checks are not always possible. Fund regulations should rely on best practices rather than on impossible rules, but no best practices for the prevention of risks have been formulated. Finally, depositaries’ liabilities have not been clearly formulated (and it will be impossible to do so as long as their obligations have

not themselves been clearly defined), which paves the way for highly divergent local interpretation. In short, depositaries run the risk of being held liable when an investment firm, short of capital, is unable to meet its obligations after losses stemming from a failure to comply with regulation. 3.4 The Influence of the French Culture on the EU Financial Laws and the Risk of Exorbitant Responsibilities for Depositaries As a result of French influence, depositaries must bear exorbitant risks in the event of the failure of a sub-custodian. As the Lehman Brothers bankruptcy and the Madoff fraud showed, a major risk is the risk of disappearance of assets or the risk of delays in returning assets, risks we call sub-custody risks. Sub-custodianship is essential to the workings of international funds, and in many cases—when an exotic jurisdiction is chosen, for example—the choice of sub-custodian is not only the depositary’s but also at least implicitly the asset manager’s. Local sub-custodianship is mandatory only in emerging economies and in mature markets such as Japan. For international funds, however, most depositaries, including the largest global depositaries, resort to sub-custodianship agreements. Bank of New York Mellon is the largest global custodian, and as it is headquartered in the United States it delegates custodianship in Europe to the best performing institutions; the largest European depositaries and custodians do likewise for many foreign investments, including in the United States. 33

33 - There are more assets under custody than held by depositaries, since custody encompasses the securities held by direct investors (individual and institutional investors) on top of securities held by collective investment schemes (CISs). In addition, as some parties are specialised in providing services to the fund industry, the classification of custodians is not necessarily the classification for depositaries.

In the current system of depositing managed assets thousands of billions of

50

An EDHEC-Risk Institute Publication