Are Hedge-Fund UCITS the Cure-All?

Are Hedge-Fund UCITS the Cure-All? — March 2010

2. Context: A Muddled Regulatory Agenda Encourages Structuring HF Strategies As UCITS

because buyers of derivatives’ assumption that counterparty risk was low, and because of the need to replace derivatives used in hedging schemes. This systemic risk and these costs for the end users of derivatives have led to the clearing of derivatives by central counterparties, i.e. , clearing houses that do not just match transactions but also assume counterparty risk (see box 6). Although central counterparty clearing houses (CCPs) will reduce counterparty risk, better collateral management in investment funds would have made it possible to mitigate counterparty risk. Despite the impact of the Lehman and Madoff affairs on the regulatory agenda, however, harmonisation, clarification and the definition of guidelines for depositaries are unfinished and must be pushed through in the short term.

In addition, there will be an impact on risk-management practices: depositaries as well as funds that invest in hedge funds will need to manage non-financial risks better. Lehman’s failure to return the assets of alternative funds it held in custody affected alternative funds that used the prime broker as a sub-custodian. This bankruptcy thus had an impact on the structure of such alternative funds, on the business model of prime brokers, and on the relationships between prime brokers and depositaries. Box 3: The failure of Lehman as a prime broker of alternative funds The lack of segregation of assets at Lehman meant that leverage funds were unable to recoup their assets immediately. This was a particular problem in France, where depositaries had an immediate and unconditional obligation of restitution—they had to compensate some ARIA EL funds for assets that had been re-hypothecated by Lehman. The bankruptcy of Lehman Prime Broker put two distinct items on the political agenda. In France, for ARIA EL funds (which use the prime broker to borrow assets), the depositary’s liabilities can be contractually lowered. In other European countries, regulators now tend to require that assets at the prime broker be properly segregated. In parallel, the failure of Lehman as a derivatives counterparty has led to high systemic risk because of the interconnection in the banking system,

2.3 Attractions of the UCITS Framework

In Europe, rules for the distribution of investment funds are complex and lack homogeneity.

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An EDHEC Risk Institute Publication