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

While this is language that has heretofore been used to describe Structured UCITS, it may leave some scope for interpretation over whether the use of derivatives by UCITS would render them unfit for execution-only distribution. 45 The proposal considers Structured UCITS to be a priori complex. While this may be questionable, this is consistent with the definition of a complex product that appears in the impact assessment released with the MiFID upgrade proposals as well as with the practice of some Member States (Amenc, Ducoulombier, Goltz, Tang, 2012). Any product deemed complex would no longer be available to self-directed investors and such a classification could also negatively impact institutional demand. The advanced nature of tools and techniques employed to deliver a payoff should not be confused with the complexity of the payoff itself. The complexity of the payoff is what characterises financial risks while the structure of the investment or the tools it employs may entail non-financial risks. Payoff complexity and financial risk We strongly believe that when it comes to categorising investment products as complex or non complex, the focus needs to be on the economic exposure achieved or the payoff generated and not on the portfolio management methods (e.g. scientific diversification) or the financial instruments (e.g. futures and options) used to engineer this exposure or payoff – there is no obvious relationship between structural or instrumental complexity and risk profile.

whose associated financial components primarily benefit the fund and its investors can only exacerbate adverse selection and moral hazard phenomena, at the expense of depositaries and the industry as a whole. Indeed if regulation leads investors to assume that non-financial risks will be borne by a third party, investors will have little incentive to assess these risks and the ability of the fund management chain to mitigate and manage these risks; in the end, investors will be unlikely to price these risks. This situation will contribute to a rise of non-financial risks in the fund management industry precisely when compliance with regulatory demands in the area increases the costs of bearing such risks. 2.2. Distribution and the question of complexity In the context of the proposed revision of MiFID, clarification is provided on instruments that can be traded via execution only services. While UCITS other than Structured UCITS are explicitly mentioned as authorised for distribution via execution-only platforms, the introductory part of the proposal states that since execution-only services entail “a relevant reduction of clients' protections,” it is appropriate “to better define the criteria for the selection of the financial instruments” to which these services should relate “in order to exclude the financial instruments, including collective investment in transferable securities (UCITS), which embed a derivative or incorporate a structure which makes it difficult for the client to understand the risk involved.”

45 - A paragraph in the impact assessment paper released by the staff commission (SEC(2011) 1226) substantiates this concern: “the classification of all UCITS as noncomplex instruments needs to be reviewed in light of the evolution of the regulatory framework for UCITS, notably when assets they can invest in are themselves considered complex under MiFID, for instance derivatives.”

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An EDHEC-Risk Institute Publication