Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry

Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry - December 2012

Introduction

different possible approaches to protect unit holders.

This publication completes the work conducted in the context of the research chair on "Risk and Regulation in the European Fund Management Industry", sponsored by CACEIS. Its objective is to summarise and update the work done in the first two years of the research chair and to put forward strong, actionable proposals to improve the protection of investors from non-financial risks. The 1985 Undertakings for Collective Investment in Transferable Securities (UCITS) Directive established the regulatory framework for the growth of a pan-European market for retail investment funds. Now managing over EUR6 trillion in assets, UCITS have proven hugely successful not only in the European Union, but also across the world where the UCITS brand has become synonymous with high level of investor protection. However, in the quarter century since inception of UCITS, non-financial risks increased unchecked by, or sometimes as a result of, regulation, an issue that was brought to the fore during the global financial crisis. The research chair’s foundation paper, “The European Fund Management Industry Needs a Better Grasp of Non-financial Risks” (Amenc and Sender, 2010), put forward a definition of non-financial risks, identified major areas of concern for the fund industry, examined the regulatory framework at the European level and in the key UCITS domiciles of Luxembourg, France, Ireland and the United Kingdom, discussed the risks and responsibilities of the various links and stakeholders in the fund management chain, and reviewed

Non-financial risks refer to such issues as loss of assets due to the default of an institution directly or indirectly (e.g. a sub custodian) providing services to a fund (counterparty risk), suspension of redemption (or subscription) by an open- ended fund as a result of failed liquidity management processes (liquidity risk). The inaugural paper contended that the increase of non-financial risks in the European fund management industry could be primarily attributed to the growing sophistication of the transactions and financial instruments of funds, and to regulatory changes that had expanded the investment freedoms of funds without considering operational consequences. The paper underlined the importance of country-level regulations and legal cultures for UCITS regulation and pointed to differences in transposition, supervision and enforcement as sources of risks. To shield investors from non- financial risks, it discussed subjecting all links in the fund management chain to regulatory capital requirements targeting non-financial risks, promoting the rating of funds for non-financial risks and the taking of insurance against non-financial risks, and improving governance and providing investors with more judicial powers to seek redress in case they suffered losses due to the materialisation of non-financial risks. The paper also envisioned the creation of a subset of UCITS for which depositaries would be unconditionally responsible for the restitution of assets.

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An EDHEC-Risk Institute Publication