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

brokers and agent lenders; it would also promote efficiency (naturally, centralised trading would do even more so) and facilitate oversight of short-selling restrictions, often an objective of regulators. The July 2012 ESMA guidelines require the UCITS to clearly inform investors in the prospectus of its intention to use EPM techniques and include a description of their risks; they also require that investors receive the full benefits of the risks taken on their behalf. 52 Where it was previously possible for the manager of a UCITS to capture part or all of the revenues generated by EPM techniques without making this clear to UCITS holders, the new ESMA guidelines not only require UCITS to disclose their policy regarding operational costs and fees arising from EPM techniques and identify the entities to which these are paid and whether these entities are related to their management company or the depositary; but also stipulate that all revenues net of operational costs must be returned to the UCITS. Depending on their structuring choices 53 and risk tolerance, UCITS compliant index- tracking vehicles can exhibit vastly different levels of gross and net counterparty risk, which are not captured by their track records or economic exposure (and therefore the KIID’s SRRI). This illustrates the point that the use of certain instruments or techniques is not sufficient to characterise the exposure of a fund to non-financial risks; an in-depth study of structures, arrangements and practices is required to assess such risks. Therefore, the emphasis should not be to map instruments onto risk categories but instead consider that a fund that carries non-financial risks that cannot be observed

or assessed by the market should not be sold without advice.

In the context of MiFID, the distributor providing investment advice or portfolio management services is required to assess suitability or adequacy of products or strategies and needs to consider both financial (payoff profile) and non-financial risks. One can conceive that professional investors be authorised to renounce advice to save on distribution or advice fees. Retail investors however should not be deprived of advice whenever a product has a complex payoff or carries non-financial risks. This presupposes that all required information has been made available to the distributor in a fair, clear and not misleading manner. How this would be possible given the scarcity of information about non-financial risks is anyone’s guess. The focus of current regulation leads to a dearth of information about non-financial risks The focus of recent regulatory effort has been on the limitation and mitigation of non-financial risks and on the insulation of investors against the consequences of its materialisation, particularly in the context of assets lost in custody. Transparency on the nature, extent and implications of non-financial risks has largely been an afterthought. This is regrettable since non-financial risks are inherent to investing and, as such, need to be suitably disclosed to allow for informed decision making. 2.3. Responsibility for Information on Non-Financial Risks

52 - Note that if the depositary were expected to make good on losses arising from counterparty default in the context of EPM programmes over which it has no control–when such programmes benefit the fund and the intermediaries managing them–moral hazard would arise to its detriment of the depositary. 53 - Some dimensions include choice of synthetic vs. physical replication; use of funded or unfunded swap for synthetic replication; use of securities lending techniques swap synthetic replication; choice of agency vs. principal programme for securities lending; choice of single or multiple counterparties for principal securities lending programmes or OTC swap; etc. by funds using physical replication or unfunded

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An EDHEC-Risk Institute Publication