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

The expansion of eligible assets has increased non-financial risks UCITS regulation was originally modelled on country regulations at a time when funds invested mainly in domestic listed securities, which made it particularly easy for depositaries to hold the bulk of assets in custody. While the scope of UCITS eligible investments and authorised techniques has been expanded with a view to keeping up with financial innovation in competitive international markets, provisions on depositaries have essentially remained unchanged for over a quarter of century. The UCITS III “Product Directive” (2001/108/ EC) expanded the original list of eligible assets beyond transferable securities to include investment in other “sufficiently liquid” financial instruments, including money market instruments, units of UCITS and other collective investment undertakings as well as banking deposits. It allowed investment in derivatives other than for hedging and efficient portfolio management. It also introduced the necessary flexibility to allow replication of indices by UCITS. The Eligible Assets Directive (EAD) clarified the meaning of important terms used in the previous directives 18 , further expanding the asset menu (while disallowing some practices that had fed on ambiguities) (2007/16/EC). 19 In the process, the percentage of assets that could not be safe-kept increased, increasing investors’ exposure to non-financial risks irrespective of the restitution obligations of depositaries. Meanwhile, with the liberalisation of foreign indirect investment flows, investors got access to new markets and international portfolio investment

to see over-the-counter (OTC) derivative contracts and positions reported to trade repositories and migrate as much of the OTC derivatives market as possible to central venues for trading and/or clearing through central counterparties (Group of Twenty, 2009). While much of the initial regulatory focus has been on the counterparty risk of OTC derivatives, funds face counterparty risk in the context of their securities lending and repurchase transactions (efficient portfolio management techniques secured by the exchange of collateral) and from their purchases of structured notes and certificates as well as warrants and contracts for differences (all of which are typically unsecured transactions) (Costandinides and Arnold, 2011). The central counterparty model holds great promises for aggregate reduction of counterparty risk in the system, but is neither appropriate for all OTC derivatives, nor can it be used for all transactions giving rise to counterparty risk. It is important that the counterparty risk arising from other investments be recognised and suitably managed; along with the use of central counterparties, better collateralisation arrangements should be sought. 1.2. Causal Factors in the Rise of Non-Financial Risks In earlier work also conducted in the context of the research chair endowed by CACEIS, we analysed the rise of non-financial risks in the fund industry and contended that its main causes were the expansion of eligible assets and authorised techniques combined with inadequate regulation and supervision (Amenc and Sender, 2010).

18 - These terms were: transferable securities,

money market instruments, liquid financial assets with respect to financial derivative instruments, transferable securities and money market instruments embedding derivatives, techniques and instruments for the purpose of efficient portfolio management, and index- replicating UCITS. 19 - As we observed in previous work, the EAD allowed investment in indices representative of such ineligible assets as commodities and hedge funds, in non-leveraged collateralised debt obligations, and even in real estate and private equity (Amenc and Sender, 2010).

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An EDHEC-Risk Institute Publication