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

Appendix: Illustration of Good Practices for the Management of Non-Financial Risks

Improving Control Over Segregated Assets When assets that can be safe-kept are entrusted to third parties as may be required when investments need to be held locally in a country where the depositary does not have a local entity entitled to do so, or where a third party is used to hold the collateral received in the context of an OTC derivatives transaction or a securities lending programme, the segregation of assets is the first line of defence. Assets should be held in a segregated account in the name of the depositary in the books of the counterparty as opposed to be held in a pool with those of other clients (omnibus segregation), or left un-segregated – this is to clarify legal claims to assets in case of a default by the counterparty. When the depositary entrusting assets to a third party is not subjected to a strictly enforced regulatory requirement to maintain a clear distinction between client assets and its own funds, then there should be further segregation in the books of the counterparty between the depositary’s own funds and those of its clients. Under AIFMD (Article 21-11-(d)-(iii)) and the UCITS V proposal (Article 22-5-(a)-(ii)), the depositary must ensure segregation of its clients’ assets not only from the third party’s assets but also from its own assets. Asset segregation at the counterparty is no guarantee against unauthorised access to the assets (as illustrated by the MF Global default, see Till (2012)) or breach of rules e.g. re-hypothecation limits (as illustrated by the default of LBIE). In times of crisis moving assets away from a stressed counterparty will be difficult as it requires benevolent cooperation on the part of a party that will experience

further stress as a result of the action. One possibility to gain some control over a sub-custodian is for the depositary to become a member of the local central securities depository (CSD) and be ready to cancel the sub-custodian’s delegation to transact in the fund’s or depositary’s name – this entails fixed costs of registration with the CSD (which may require local presence) and additional reconciliation procedures. In any case, the depositary should also request the counterparty to segregate assets at the central counterparty (CCP) level, in individually segregated indirect accounts if possible (or in an omnibus client account otherwise). Leaving collateral with the broker should be avoided; when it is not possible for the depositary to act as custodian of the collateral, a tri-partite agreement between the depositary, the broker, and a trusted independent sub-custodian is a relevant tool to mitigate risk. Counterparty risks can be reduced by regulatory initiatives such as the creation of central counterparties (CCPs), which legally interpose themselves between the counterparties to the contracts and, in essence, become the buyer to every seller and the seller to every buyer and are responsible for the operation of a clearing system (to establish positions and ensure that financial instruments or cash are available to secure the exposures arising from the positions). Reducing Counterparty Risks: Central Counterparties and Tripartite Agreements

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An EDHEC-Risk Institute Publication