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

accompanied economic globalisation. Since not one depositary or custodian maintains a custody network covering all jurisdictions, international investment will typically involve sub-custody and reliance on multiple market infrastructures, thus leading to increased restitution risk – the term global custodian should not be taken too literally. Whereas outright leverage of UCITS has always been strictly limited, 20 the authorisation of derivatives as investments in their own right gained funds more flexibility with respect to synthetic leverage. In the current UCITS framework, leverage from financial derivatives is limited to 100% of the NAV if measured with the commitment approach but can be significantly higher for sophisticated UCITS employing the value at risk (VaR) approach to measuring global exposure (2009/65/EC, 2010/43/ EU, CESR/10-788), which has allowed the development of such funds. According to the respondents of our European survey on non-financial risks (Amenc, Cocquemas, Sender, 2012), the increased sophistication of operations indeed provides the key explanation for the rise of non-financial risks in the fund management industry: 77% of the professionals surveyed consider it important or very important, while only 1% of respondents judge it irrelevant. The second most important cause identified by respondents is the reduced capacity of some intermediaries to guarantee the return of assets: 59% of the professionals surveyed described it as important or very important (16% considered it irrelevant). About half (48%) of the respondents

also considered the internationalisation of the fund management industry as important or very important (23% saw it as irrelevant). Inadequate regulation and improper supervision contributed to increased non-financial risks The need for European harmonisation to reduce regulatory and supervisory competition Regulatory and supervisory competition between countries in their implementation of the UCITS framework has been facilitated by gaps or vagueness of some terms in European regulation and by the proportionality and subsidiarity principles at the heart of the European project. The latter is illustrated by the reliance on directives – which, in contrast to immediately applicable Regulations, need to be transposed into Member State laws, which opens the door to incomplete, selective, or partial application of European regulation; 21 the related non-binding nature of Level III recommendations in the Lamfalussy process; and the traditional reluctance to harmonise sanctions, sanctioning powers, and the use thereof. Gaps and ambiguities in European fund management regulation affect some of the core elements of the framework. For example, the UCITS definitions of eligible assets leave room for interpretation. With some Member State regulators electing to clarify definitions with their own lists of eligible assets or eligibility criteria and others remaining silent, asset menus vary with jurisdiction, as mentioned in our review of the incidents

20 - Since inception and by way of derogation, Member States have been allowed to authorise UCITS to borrow, on a temporary basis, the equivalent of 10% of the funds’ assets. Additionally, borrowing for up to 10% of the assets is allowed for acquisition of immovable property essential for the direct pursuit of business, but total borrowing cannot exceed 15 % of assets (85/611/EEC, 2009/65/EC). 21 - Which is in direct contradiction to the Treaty on the Functioning of the European Union, which states that a directive is binding (Article 288, European Union, 2010). In this subsection, we assume that directives have been faithfully transposed; problems are compounded by unequal transposition, see Amenc and Sender (2010) for an illustration of the unequal transposition of the UCITS rule prohibiting investment in precious metals or certificates representing them.

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An EDHEC-Risk Institute Publication