The recent financial crisis shed light on a number of new sources of risk. On the one hand there was the extreme correlation between the real estate mortgage and equity markets, and on the other hand the extreme price sensitivity of all assets to the counterparty and liquidity risks of the financial system with respect to off-balance-sheet operations such as securitisation.

Despite being quite pronounced in 2007/08, the first type of risk was regarded, after the fact, as a logical consequence of increasingly globalised markets and probably of theoretical character – from the perspectives of both investors and regulators – of the very idea of distinct asset classes or categories and the reduction of this risk through its dissemination.

The second type of risk led regulators to absolutely want to reduce counterparty and liquidity risks by strongly stressing the need to increase regulatory pressure with regard to proper management of these risks by actors in the financial world.

Ineffective and dangerous empowerment of depositary

Within the fund management industry, this focus paradoxically led the regulator not to question the extent of operations and assets eligible for regulated funds (and on a European level particularly the flagship investment vehicles that are undertakings for collective investment in transferable securities or UCITS), but rather to focus on non-financial risks within funds and call for a trusted third party – the depositary – to act as a guarantor for the risks taken by all parties.

We believe this approach is wholly ineffective and dangerous to say the least. Ineffective because, in the end, the goal of fully protecting an investor’s assets against non-financial risks by subjecting the depositary to restrictive regulation does not stand up to a careful analysis of how these risk materialise and how they can be controlled. Short of transforming the depositary into an insurer – although it does not have the required regulatory status, earnings or capital to play this role – it would be impossible to demand the restitution of assets which do not fall under its control. Ultimately, the protection that can be provided by a depositary is limited and does not cover all non-financial risks, and the obligation of restitution put into law or put forward by the legislator only relates to a portion of the assets.

This approach is dangerous because in terms of protecting investor interests, we believe it is highly counter-productive to “oversell” the objective of security when neither regulation nor its current state of implementation can uphold such a promise and security-related rhetoric.

Regardless of the architecture of the laws on the management of non-financial risks within the UCITS framework, these risks will continue to exist and thus potentially materialise [again]. Hence, encouraging investors to believe that regulation can solve everything leads them to let their guard down against these risks and does not motivate them to conduct the essential analysis and due diligence that is their responsibility.

For EDHEC-Risk Institute, the sophistication of UCITS is one of the principal causes of the rise in non-financial risks. These risks are not the direct result of positions taken by funds on financial markets and for which they receive a reward proportional to their exposure, but rather produced by the operation of the value chain of the collective investment management industry itself.

This analysis also leads to the conclusion that current regulation (AIFMD, UCITS V, MiFID II, IMD II, PRIPS and EMIR), even if it does contain positive elements in terms of investor protection against non-financial risks, will not really solve the problem. The emphasis put on the depositary’s obligation to return assets (AIFMD and UCITS V) does not directly encourage other stakeholders in the value chain to contribute to the improvement of information and to manage non-financial risks better.

Encompassing very heterogeneous products as far as non-financial risks are concerned, the UCITS label has been questioned in recent years and is no longer the undisputed hallmark of safety supporting the international development of the European fund management industry. In this context, the creation of a new UCITS category that carries virtually no nonfinancial risk could prove an attractive brand on the global fund market.

ALLOW INVESTORS TO BETTER PROTECT THEMSELVES
This is why the research that we have conducted has led to three major proposals. The idea is to allow investors to better protect themselves against non-financial risks by availing themselves of the best information possible on the non-financial risks of funds and being warned of the depositary’s liability limits.
Reinforce information on non-financial risks The first recommendation relates to the reinforcement of information on non-financial risks, particularly with a requirement for the Key Investor Information Document (KIID) to contain a description of gross risk exposure and how to manage these risks, as well as a synthetic indicator of the fund’s net risks. In the same vein, the duty to advise, as prescribed within MiFID, would be reinforced with respect to non-financial risks.
Increase responsibility of all players The second recommendation aims to increase the responsibility of all actors within the fund management industry. This new system of shared responsibility breaks with the idea that depositaries can protect investors from all non-financial risks, which are often taken by fund managers. It will lead to the creation of incentives to better manage non-financial risks by associating the level of required regulatory capital with the level of residual non-financial risk taken by the major players in the value chain. In this perspective, EDHEC-Risk Institute does not favour the idea of extending the Investor Compensation Scheme Directive (ICSD) to UCITS : its excessive cost and failure to effectively take risks into account lead, at best, to a lack of accountability among actors and, at worst, to opportunistic risk-taking (moral hazard).
Introduce “restricted” label Lastly, with what is probably our flagship proposal, we recommend that as a reaction to the sophistication of UCITS, made possible by the evolution in regulations such as UCITS III and EAD, and exploited to the absolute limit by NewCITS, a level of sophistication which potentially exposes investors to greater non-financial risks, a new label of “Restricted UCITS ” be created. With the new label of Restricted UCITS, our aim is to allow non-professional investors to have access to a specific form of UCITS for which the depositary is liable for the full restitution of all assets. In some ways, the concept of Restricted UCITS is a mirror image of NewCITS, which left investors exposed to greater non-financial risks given the nature of operations and assets eligible within the post-UCITS III framework. It is a reasonable response to a call for more security for the operations of actors within the fund management industry value chain. Its prescriptive nature also prevents the potential scenario of escalation in which depositaries would attempt to satisfy their clients by offering guarantees for risks they cannot really control. Additionally, we believe that this Restricted UCITS proposal is a better response to the issue of non-financial risk control than the attempt to distinguish between complex and non-complex products, which leads more towards questions about an average investor’s ability to understand financial risks and fund pay-offs rather than to a relevant approach to ascertain whether non-financial risks are present.

Noël Amenc is director of EDHEC-Risk Institute, and Frédéric Ducoulombier is director of EDHEC Risk Institute—Asia.

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