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

UCITS now happens outside of the European Union, in the rest of Europe, Latin America and Asia. In this context, there are understandable apprehensions about the damage to the brand that could result from carving out and promoting a segment of the UCITS universe as “secure UCITS”. Half of the respondents in our recent survey agreed that such a label would confuse the definition of UCITS funds and thus be detrimental to the UCITS brand. It is probable that the use of the word “secure” should be avoided as it may very well create a sense of insecurity that would not be commensurate with the relative importance of non-financial risks (and may also create misplaced expectations of security about financial risks) – overall, losses directly caused by non-financial risks, even in the context of the global financial crisis, are dwarfed by losses caused by financial risk. The interplay between non-financial risks and financial risk, however, can have catastrophic consequences and non-financial risks deserve attention. With respect to the integrity of the brand, one should not overlook the fact that, ever since new investment freedoms were introduced by the UCITS III Directives (2001/107/EC and 2001/108/EC) 76 and the Eligible Assets Directive (2007/16/EC) 77 , there have been concerns about complexity and opacity in some realms. 78 The alternative investment industry’s taste for embracing the UCITS wrapper to offer funds (nicknamed NewCITS) fuelled fears that retail investor could get access to complex product via UCITS; Hong Kong is a case in point. 79 Such concerns have not been limited to third

party countries as cracks have appeared in the UCITS heartland. In October 2010, the French regulator introduced new marketing requirements for structured funds and complex debt securities (AMF, 2010) to reduce the risk of mis-selling to retail investors (i.e. the risk that clients do not understand the risks incurred and/ or the product being offered). Products were divided into three subsets: highly complex structured financial instruments with a high risk of mis-selling, henceforth banned for retail marketing; complex structured financial instruments with a possible risk of mis-selling, henceforth deemed not suitable for the MiFID execution only regime; and other financial instruments. This national regulation applies to both UCITS and non-UCITS products. The draft MiFID II proposal shows that the Commission is ready to consider at least Structured UCITS as a priori complex instruments. 80 The rise of NewCITS has also fuelled fears that the UCITS brand could be tarnished by a high-profile failure of a fund using the freedoms of UCITS III and EAD to take excessive risks. Our proposed framework would allow addressing the need for retail investor protection illustrated by the above concerns (via restricted UCITS) while preserving access to a wide spectrum of funds (outside the restricted space). In this context, we consider that our proposal would allow meeting the diverse needs and expectations of regulators in the European Union and third-party jurisdictions with respect to the balance between financial innovation, regulatory oversight, and investor protection.

76 - 2001/108/EC (a.k.a. “Product Directive”) expanded the original list of eligible assets beyond transferable securities to include investment in other sufficiently liquid financial instruments, including money market instruments, units of UCITS and other collective investment undertakings as well as banking deposits. It allowed investment in derivatives other than for hedging and efficient portfolio management. It also introduced the necessary flexibility to allow replication of indices by UCITS. 2001/107/EC (a.k.a. “Management Directive”) strengthened the regulation of management companies and created the simplified prospectus (now superseded by the KIID). 77 - 2007/16/EC clarifies the meaning of terms used in the original directives (transferable securities, money market instruments, liquid financial assets with respect to financial derivative instruments, transferable securities and money market instruments embedding derivatives, techniques and instruments for the purpose of efficient portfolio management, and index-replicating UCITS. 78 - While efficient portfolio management techniques have been authorised since the inception of UCITS, they had not attracted much regulatory attention prior to the global financial crisis. 79 - UCITS are dominant in all three of Asia’s key offshore markets. In Singapore, registration is through a simple notification; the process is comparable in Taiwan but restrictions apply to funds that use derivatives. Hong Kong requires funds to go through a full authorisation process and initiated a fast-tracking procedure with UCITS III ; however this has become a slow and sometimes intractable process for many funds; specific areas of attention include use of derivatives, leverage and, of late, securities lending. recognition that some UCITS are complex in the context of MiFID II (albeit on the basis of payoff complexity and investor’s ability to understand the product and its risks, rather than on the product’s use of certain instruments or methods, which is aligned with our recommendations.) 80 - The French regulator is understood to be lobbying European authorities for

72

An EDHEC-Risk Institute Publication