A Better Grasp of Non-financial Risks

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

Executive Summary

This research chair on risk and regulation in the European fund industry deals with the European regulatory framework for the fund industry and focuses on the situation in France, the United Kingdom, Luxembourg, and Ireland; regulation in the United States is examined as well. The UCITS directive fails to make adequate allowances for the operational consequences of financial innovation. Although investment funds have diversified internationally, made growing use of derivatives and other sophisticated strategies, and evolved in other ways, and although EU regulators (eligible assets directive) and EU recommendations (recommendation on sophisticated UCITS that can make more extensive use of leverage) have recognised or even favoured these changes, they have failed to do studies on their impact and they have failed to modify regulation accordingly. Madoff showed that a massive fraud made possible the disappearance of all assets in a UCITS, the retail product supposedly affording the highest degree of investor protection, and this without the supervisory authorities or any of the parties involved in the security of unit-holders (the investment firm, the board of directors, the depositary) being able either to guarantee the security of the UCITS fund or to make good on the losses of unit-holders. In addition, the bankruptcy of Lehman Brothers, a highly rated and prestigious institution subject to banking regulation, led to the disappearance of some assets of alternative investment funds and long delays in returning remaining assets even though such institutions were implicitly considered immune to the risk of bankruptcy by regulators. Although the major impact

of the Lehman bankruptcy may have been on alternative funds, this bankruptcy must lead us to question the implicit reliance of UCITS regulation on the assumption that sub-custodians cannot fail. That protection offered by depositaries is subject to legal interpretations and varies widely within Europe, variations that also occur in the supposedly unified scope of UCITS, means that UCITS, before being a European brand, is country specific. On the whole, Madoff and Lehman raised sufficient concerns for politicians to agree on an agenda focused on a better definition and a strengthening of depositaries’ responsibilities. Non-financial risks increased, and regulations contributed to this rise. Non-financial risks are risks that arise because of failed processes or failed counterparties and that include the risk of assets not being returned at all as opposed to the financial risk of having low returns on assets. The rise of non-financial risks in investment funds has various causes. The former is the result of financial innovation, which has greatly increased the sophistication and complexity of the transactions made by investment funds and the financial instruments they use. The latter is the result of regulation unsuited to this growing sophistication. The UCITS directive was originally drafted when funds invested, in the main, in domestic listed securities and when depositaries could ensure the safekeeping of assets. With the sophistication of fund management techniques and the growing number of asset classes used to capture risk premia, funds invested in derivatives and extended their holdings of securities with sub-custodians and registrars in

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An EDHEC-Risk Publication