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

3. Proposal towards Better Management of Non-Financial Risks

targeted capital charges), the objective of this recommendation is to reduce non-financial risks to an absolute minimum within a subset of the UCITS universe by restricting assets and practices that are inherently risky. This subset of funds is intended for investors that cannot verify adherence to best practices by UCITS managers or that can only accept the minimum amount of non-financial risks. Naturally, depositary institutions offering such extended guarantees of restitution would need to be subjected to specific prudential requirements, lest moral hazard and systemic risk be increased by the operations of overly aggressive or less than honest providers, which could capture market shares by offering guarantees low costs, foster a race to the bottom, and go bankrupt when risk eventually materialises. Contours The depositary of a restricted UCITS would have a fiduciary duty vis-à-vis the fund’s investors and guarantee the unconditional restitution of assets lost as a result of the materialisation of non-financial risk, with narrow exceptions for Acts of Nature, Acts of States and systemic failures such as the default of a CCP or of a CSD. This obligation and its framework would arise from a legal definition by the regulator which would include very significant restrictions on eligible assets and practices. Making assets ineligible would restrict the investment universe; investment limits would further narrow the attainable risk-reward profiles; restrictions on efficient portfolio management would reduce ancillary revenues; adherence to the highest standards for the management of

non-financial risks by construction. This subcategory of funds, named restricted UCITS, would notably be meant for retail investors. This proposal addresses the observation that with the evolution of the UCITS framework, the UCITS label is applied to funds that are exposed to widely different levels of non-financial risks. The investment freedoms introduced by UCITS III and the EAD, have led to the rise of NewCITS and their offering to non-professional clients. We consider that this growth will not be halted by the AIFM Directive since the latter targets distribution to professional investors and leaves each Member State to decide whether, and in what condition, it may allow marketing of alternative investment funds to non professionals (Article 43 (1)). This development is problematic from the point of view of the brand legibility of UCITS which has so much contributed to the success of the European fund management industry. Specifically, our recommendation is to align the liability regime of UCITS depositaries with that of the AIFMD (with implementing measures derived from ESMA’s technical advice to the Commission) notably allowing the same contractual discharges and related transparency obligations, and simultaneously encourage the creation of a subset of UCITS that would be covered by an unconditional guarantee of restitution, with relief limited to narrow force majeure circumstances. While our previous proposals aimed to promote a reduction of non-financial risks across the fund management industry and through the adoption of best practices (supported by enhanced transparency requirements, better governance, and

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An EDHEC-Risk Institute Publication