A Better Grasp of Non-financial Risks

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

4. Which Possible Protection of Unit-Holders?

class action can enable investors to finance the legal and financial consultations necessary to the defence of their interests and to obtaining fair compensation for any damages. The use of class action should not imply punishment—financial penalties above and beyond reparation for damages— usually associated with class actions: the idea is to ensure reparations are made, not to punish. The subsidiarity principle The common-law approach to regulation is founded on the principle that all parties are informed and consenting. The subsidiarity principle is at the heart of English law; the general principle is to determine responsibility for any losses and act accordingly. To incorporate this approach into European law more formally, the subsidiarity principle and the notion of informed parties could serve as the cornerstones of a directive on the sound management of the non-financial risks in UCITS; the scope could be greater than that of a mere depositary directive. We have seen that in the United Kingdom the failure to define sound risk management practices and the vagueness of the responsibilities of the depositary (see the MGAM case) and the investment firms have created great uncertainty, above all for small, not highly capitalised investment firms. So such a directive would have to deal with all of the problems mentioned in common law and to define with precision a) the responsibilities of the investment firm (including standards of documentation and transparency of risk management and conflicts of interest), b) the financial soundness of investment firms (capital requirements and coverage of non-financial risks), c) the liability of

depositaries in the event of losses arising from an investment firm’s failure to comply with rules and to honour its commitments, d) the responsibilities for the choice of sub-custodian in exotic jurisdictions or directly chosen by the investment firm (prime brokers), and e) the outside events (such as the immobilisation of segregated assets in application of the laws of the country of the sub-custodian) that may prevent the depositary from returning assets. With these definitions made clear, it would be possible to require of the depositary immediate restitution of assets unless the depositary can prove that other parties were at fault or failed to disclose information or unless it is prevented by foreign law from returning assets. If assets really are segregated by the sub-custodians, it would then be possible to return them to the investment firms (or to the unit-holders). Better governance should allow better risk management, but better techniques are also needed. Finance practitioners often fail to apply state-of-the art techniques, let alone invent or improve techniques. Techniques can be improved with appropriate regulatory guidelines, or with appropriate guidelines and best practices from industry working groups. Counterparty risks in derivatives can be reduced by regulatory initiatives such as the creation of central counterparties (CCPs), which are a buyer to every seller and a seller to every buyer; in effect, they do away with counterparty risks altogether. CCPs, however, require that margins be set as cash on a daily basis, a requirement that Counterparty risk and collateral management

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An EDHEC-Risk Institute Publication