A Better Grasp of Non-financial Risks

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

Executive Summary

geographies that required local custody. Misleading regulatory certification based on inappropriate rules, such as liquidity requirements, contributed to the rise of adverse selection and misselling (by which products are misrepresented) and, in the end, to a rise in risks for those who relied on these certifications. Adverse selection and misselling are especially worrying in the retail landscape because investors cannot make informed decisions. The growing sophistication of funds, as well as their greater use of derivatives and of international assets that require external sub-custody, has made bookkeeping and the monitoring of the compliance of the fund and the supervision of sub-custodians ever more important, especially as derivatives hide the underlying exposures and sometimes the true nature of risks. Although making more assets eligible has led to greater demands being made of fund management firms, with the spelling out of a programme of activities specific to the instruments dealt with, the regulators’ failure to take post-market problems into account until very recently means that the European framework fails to define for the depositary either the obligations or the liability associated with custody of these instruments. In article 9 of the UCITS directive (EC 2008), the depositary is entrusted with the assets for safe-keeping but is responsible only for the consequences of its unjustifiable failure to perform (undefined) obligations. 1 So, the failure to update depositary regulations has meant that investments in derivatives deprive UCITS regulation of its substance and allowed risks to increase. Last, regulatory competition between countries in their implementation of the UCITS directive and of European recommendations was facilitated first because of loopholes in EU

laws (such as the lack of definition of duties associated with bookkeeping and with the sub-custody of assets) and second because the EU merely issues recommendations for the convergence of country laws. 2 A determination to harmonise the depositary liability regime that has not yet been fully transposed into regulation and that should not mask the need to manage non-financial risks throughout the fund management industry. As the Madoff fraud made clear that heterogeneity in the protection of unit-holders could undermine the single market for funds in Europe, a political agenda sprang from a desire to clarify, homogenise, and strengthen the UCITS regime, particularly as regards the liability of depositaries. In May 2009, Charlie McCreevy, Internal Market Commissioner, announced that he intended to clarify and strengthen the provisions of the UCITS regime, in particular those regarding the liability of depositaries. The Committee of European Securities Regulators reviewed the liability regime of the UCITS depositaries in the twenty-seven member states and concluded that depositaries’ obligations of safekeeping and control laid out in the UCITS directive have been transposed in diverging ways by member states. Country regulations can then be understood by their legal origins more than by EU laws. Common- law systems rely on the assumption that extended fiduciary duties and adequate information of agents are sufficient, but law enforcement relies on costly court procedures. Civil-law systems, in which regulators detail the procedures to be followed by depositaries and entrust them with a strong mission of control and great responsibilities to the end-investor, rely on the assumption that an administrative

1 - As this document was being finished, UCITS IV was passed by the European parliament but not yet implemented in country regulations. To compare EU regulation and that enacted in individual countries, we have used references to UCITS III throughout the document when UCITS IV does not bring material changes. 2 - Technically, 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; EU recommendations are—as shall probably be expected— not binding. EU laws rely on national legal regimes.

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An EDHEC-Risk Publication