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

1. Regulation and Non-Financial Risks

professional and non-professional investors alike to seek redress via lengthy, costly and uncertain legal procedures. Freezing and rescues of open-ended funds: liquidity risk management and reputational risks Money Market Funds Money market funds (MMFs) have traditionally been a reliable tool for cash management as they combined excellent liquidity, competitive returns and minimal downside risk. It thus came as a surprise to most that the MMF market was the first to be hit by the subprime crisis and that it later played a significant role in the dislocation of financial markets. While the subprime crisis hit the MMF market in Europe and the United States at the same time, the most visible cracks first appeared in Europe. US sponsors have traditionally marketed MMFs as ultra-safe instruments and maintained an implicit promise of keeping the NAV of their funds constant at one dollar 9 by historically bailing out the funds that were in trouble. The pledge was respected in the first phase of the financial crisis since no United States MMF “broke the buck” between 1994 and the default of Lehman Brothers; however, in this phase sponsors had to rescue MMFs to the tune of several billion dollars by buying impaired mortgage-related securities from the funds or injecting cash into them (Bengtsson, 2011). European MMFs are typically set up as UCITS with France, Luxembourg and Ireland as the main domiciles. Constant Net Asset

Value (NAV) and variable NAV funds manage equal pools of money with the variable model being dominant on the continent and the constant model in Ireland and the United Kingdom. Reflecting differences in the transposition of the UCITS directives by Member States, restrictions on eligible assets vary significantly from one European jurisdiction to another. In France, where an asset manager needs the approval of the Financial Markets Authority (AMF) to offer an investment fund as an MMF, the enhanced MMF segment was particularly developed. Enhanced (a.k.a. dynamic) MMFs seek higher yields than other MMFs through investment in lower-quality and/ or longer-dated instruments, including non-traditional investments such as asset- backed or mortgage-backed securities (ABS/MBS). Prior to the sub-prime crisis, the experience with these non-traditional investments was satisfying in terms of credit events or secondary-market liquidity (Bengtsson, 2011). Trouble in the asset- backed securities market that erupted in July 2007 caused massive redemptions in the European MMF market as investors had insufficient transparency on the risks of instruments held by the funds they were holding; some of the MMFs exposed to illiquid or impaired assets had to suspend redemptions, wind down, or call their parents for help. In July 2007, AXA Investment Management Luxembourg announced it would be investing its own money to match the redemptions in two of its funds and was suspending subscriptions. Both funds were heavily invested in the subprime market and had suffered precipitous losses. As the underlying market had become illiquid, the manager took this exceptional step to avoid having to liquidate its holdings and fuel

9 - Interest is thus paid by share distributions.

33

An EDHEC-Risk Institute Publication