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

(Ducoulombier, 2012). With respect to financial risk, this is consistent with the focus on payoff which the regulator has otherwise used when approaching the structured UCITS category. However, in this debate, non-financial risks, and in particular counterparty risk, were at the forefront. Irrespective of the payoff profile, reliance on specific instruments and techniques, whether central to the delivery of the payoff (such as OTC total return swaps in synthetic replication funds or investment in certificates to access certain emerging markets) or undertaken to reduce risks, costs, or generate ancillary income i.e. Efficient Portfolio Management (EPM) techniques such as securities lending under UCITS 49 , creates or increases exposure to non-financial risks. The debate on the purported risks of UCITS ETFs conducted in 2011/2012 by ESMA (ESMA/2011/220, ESMA/2012/44) has led to progress in the understanding of counterparty risk and its mitigation and to a more consistent approach to its limitation and mitigation. In this context, we underlined (Amenc, Ducoulombier, Goltz and Tang, 2012) that while net counterparty risk from OTC derivatives operations was limited to 5% (or 10% if the counterparty is a credit institution) of the net asset value (NAV) of the UCITS, there was no limit other than the 20% issuer concentration limit applying to efficient portfolio management techniques such as securities lending (or other sources of counterparty risk for that matter). In our exchanges with ESMA, we suggested applying uniform limits and mitigation standards (e.g. collateralisation) Non-financial risks arising from portfolio management

across UCITS (Amenc and Ducoulombier, 2012).

The July 2012 ESMA guidelines on ETFs and other UCITS issues (ESMA/2012/474) went a long way towards this objective by requiring the risk exposures from OTC financial derivatives and so-called efficient portfolio management (EPM) techniques to be combined when calculating the issuer concentration limit and imposing the same rules on collateral for both types of operations (Ducoulombier, 2012). 50 Worldwide the attention has shifted from the counterparty risk associated with OTC derivatives – new standards on central clearing and collateralisation of bilateral trades have further reduced the risks in this space – to the counterparty risk present in securities lending which had traditionally received less attention (with some jurisdictional exceptions e.g. Ireland). The role of Lehman Brothers as a securities borrower (which routinely rehypothecated the collateral posted by its clients) and of AIG as an agent lender (which reinvested the cash collateral received by its insurance subsidiaries in large part in residential mortgage-backed securities) have been overshadowed by their centrality as counterparties in the CDS market. 51 Interestingly, securities lending operations (and repurchase agreements) have not been required to migrate to central clearing, but risk-based capital adequacy regulation will exert pressure even in the absence of direct regulatory intervention. Clearing of securities lending operation by adequately regulated central counterparties could reduce systemic risk since the industry is concentrated in the hands of a few prime

49 - Article 21(2) of Directive 2007/16/EC clarifying Directive 85/611/EEC. 50 - While this falls short of applying the stringent risk mitigation requirements defined for OTC derivatives to all operations generating counterparty risk, since the concentration limit is twice to four times as high as the counterparty risk limit in use for OTC derivatives, this is a step in the right direction. 51 - The July 2012 ESMA guidelines have not failed to also underline the need for liquidity risk management processes to recognise the non-financial liquidity risks linked to the use of EPM techniques.

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An EDHEC-Risk Institute Publication