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

Executive Summary

liability to return lost assets would allow the two major non-financial risks to be addressed – namely (i) the consequences of counterparty default within the fund management value chain (for example, the default of the counterparty in a securities lending/borrowing operation or an OTC derivative); or (ii) the poor assessment/ structuring of a fund’s liquidity, thereby subjecting the investor to a loss due to the illiquidity of a fund that was initially branded liquid. EDHEC-Risk Institute considers that this dual approach – even if it has led the regulator to comprehensively investigate the sources of non-financial risks and allowed for them to be better managed – needs to be brought into question. It is contestable firstly, as some forms of investment management are indissociable from certain forms of non-financial risk taking, with investors willingly accepting these risks rather than beingmerely subjected to them. As such, investing in hedge funds – which are often not subject to stringent regulation – carries the assumption that investors are well aware of and accept the non-financial risks of these funds; while they certainly wish to limit these risks as much as possible, they are recognised and factored into required returns. On this basis, we note that the required returns of hedge fund strategies offered through managed account platforms which reduce operational risk are lower than those of hedge funds which are managed and held in custody offshore. In the same vein, investing in certain emerging equity markets naturally exposes investors to infrastructure and market risks at large; compared to transactions carried out on more secure

markets, these are supplementary risks which are duly factored into the price of assets. Exposure to non-financial risks can often result in direct remuneration as is the case with securities lending/borrowing activities for which the asking price does not solely depend on financial factors (interest rates, supply and demand for the security), but also on non-financial factors (the organisation, structure and level of collateral; the quality of the counterparty; the stature of the lending agent and the terms and conditions of the securities lending and borrowing agreement, etc.). Secondly, from a systemic point of view, it seems rather dangerous to put the liability for asset restitution solely on the depositary, particularly within an industry characterised by a high concentration of players and low levels of shareholder equity. Concentration is derived from economies of scale and specialisation, and along with low capital intensity, allows post market operations to be optimised in terms of value for money.) Lastly, we certainly view it as risky to let investors and the industry at large believe that one law or a single stakeholder can solve everything. In the end, whether it be via UCITS V or the AIFMD, the depositary’s responsibility for restitution will not cover all assets and notably, not the operations and instruments which do not fall under the depositary’s control. So, any communication around a regulation that professes to be more secure, but which in reality turns out not to be so will only serve to magnify the phenomena of adverse selection and moral hazard. We must thus, at all costs, avoid making investors believe that they can rely on the law or an external third party for protection against

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An EDHEC-Risk Institute Publication