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

2. Key Topics on the European Regulatory Agenda

high costs that will be passed through to investors.

As things stand, the burden of non-financial risks as materialised by asset losses – and other losses when linked to negligence or intentional failure to properly perform – falls upon the depositary. While this link is better capitalised than the fund manager whose actions most strongly impact non-financial risks, its reserves still fall short of what would be required to implement the proposed guarantee. Such stringent liabilities and inability to discharge of liability by contract in the context of UCITS V could prompt depositaries to reconsider the extent and costs of services offered to UCITS; depositaries could choose to shun asset classes or geographies or charge higher fees to meet the increased operational costs of their new regulatory obligations and compensate them for their added liabilities. This would restrict choice and costs in the UCITS space. Depending on business dynamics, this could lead to concentration of risks within some depositaries for good (higher expertise) or bad (higher risk tolerance) reasons and has potential to conflict with the regulator’s concern for reducing systemic risk. Against this backdrop, we reiterate (after Amenc, Cocquemas, Sender, 2012) our suggestion that the AIFMD rules apply to UCITS depositaries. The Commission (correctly) judges that outright banning of non compliant third country sub-custodians would reduce investment opportunities for UCITS investors and that (arguably) the risk is negligible anyway because of UCITS’ mostly conservative investment strategies. Effective choice may nevertheless be restricted by the decisions of custodians to shun coverage of some markets or impose

More generally, strengthened capital requirements and/or higher liability risks in the new environment may prompt further concentration of the depositary industry and/or, as mentioned already, risk-based specialisation, both of which have negative consequences in terms of systematic risks. One should underline that an unintended consequence of establishing a strict liability regime for the restitution of assets under custody only could be to create expectations of guaranteed restitution of all assets when it is not possible. The depositary cannot safe keep OTC derivatives or assets whose ownership and control has been transferred to third parties such as securities used in efficient portfolio management transactions. 44 Besides, there will still be instances where the depositary will be in a position to discharge its liability and it is unclear how the ICSD guarantees would apply to non-professional investors in UCTIS, should the scheme be revised in this direction, which seems elusive. As an aside, it is interesting to remark that the investor’s responsibility is never mentioned. Non-financial risks are a part of investment risk and can be the price to pay to access high-risk high-return investments. There is no obvious reason why depositaries should be compensating other links in the fund management chain or investors for the materialisation of political risk when it was accepted by the fund manager and (hopefully) the investor. Making the depositary the insurer of first (and last) resort for non-financial risks that arise as a result of the fund’s actions and

44 - Note that the Delegated Regulation (in its Recital 100) proposes landmark changes to collateral custody practices as it requires, inter alia, that assets provided as collateral be effectively kept in custody as long as they remain the property of the fund. The simplest of several possibilities is for the collateral to remain with the depositary and be earmarked in favour of the collateral taker. This does not affect transactions whereby full ownership is transferred to the collateral taker but forces the depositary to keep under custody assets whose possession is transferred to the collateral taker under a security right such as a pledge.

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An EDHEC-Risk Institute Publication