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?

results in higher funding costs for banks, long-only equity funds, and other cash-poor funds. This option sheds counterparty risk, but the higher liquidity requirements for banks may raise the price of derivatives. In addition, the requirement to post cash as collateral penalises funds that do not usually hold cash. After all, because of margin calls, the volatility in the price of the derivative results in volatility of the cash account for the investment fund, and the fund may need to sell assets, generating transaction costs, to free cash. So, the private sector could also improve collateral management by relying on tri-partyagreements andover-collateralising contracts with less liquid instruments. This solution would make it possible to shed counterparty risk and get around the costs of posting cash or liquid instruments for the margin requirements of centrally cleared derivatives: equities could be posted as collateral, and counterparty risk could thus be shed without weighing too heavily on liquidity. It would also make it possible for funds that attempt to invest fully in an asset class to hedge some risk factors with derivatives, yet remain fully invested at all times. Liquidity risk management Long-term institutional investors can invest in illiquid assets but they must assess the risk and return characteristics of funds. Because institutional investors have large balance sheets and are able to hire specialist managers for each type of risk they buy, they may seek appropriate vehicles for illiquid strategies. To some extent, it is illusory to use UCITS to distribute illiquid strategies because UCITS is a framework based on the liquidity of assets and liabilities (units). To

lower the risk of misleading certifications, regulatory bodies could study the suitability of closed-end funds that would ensure a match between the assets and liabilities of the fund: by ensuring that liabilities have a long horizon, the fund can safely invest in less liquid assets (Amenc 2009; Amenc, Schoeffler, and Lasserre 2010). Investors locked in a fund for years cannot as easily exercise their power to exit, and asset managers can be sure that they will go on managing assets and collecting fees regardless of the quality of their management. So, further transparency and better governance mechanisms are needed to ensure the success of such funds. Further study of governance in the fund management industry is necessary before European closed-end funds can be created. History has also shown that the UCITS requirements for liquidity are very vague; that there is a liquid secondary market when an asset is bought does not mean that the asset will be liquid at any time in the future. All derivatives based on illiquid assets run the risk of becoming illiquid, as the market for mortgage-backed securities has shown. The fund industry could also implement liquidity risk management techniques, examples of which can be found in the literature on the risk management of hedge funds. De Souza and Smirnov (2004) note that investors have a limited tolerance for losses and that large losses may trigger redemptions. The primary objective of liquidity risk management is to avoid reaching the critical point at which counterparty obligations or investor redemptions are large enough for the necessary sale of assets to have

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An EDHEC-Risk Institute Publication