UCITS, the European retail regulated investment funds, were created shortly after the 1985 passage of the first UCITS directive. Since then, non-financial risks have increased, but European authorities and investment professionals failed to study the impact of these risks when they allowed UCITS funds to evolve.
The increase of non-financial risks in investment funds is the result above all of the growing sophistication of the transactions and financial instruments of investment funds, of the pursuit of non-traditional risk premia, as well as of such regulatory actions as the passage of the eligible assets directive (EAD) and the improved possibilities for leverage in sophisticated UCITS. In addition, inappropriate regulatory certification contributed to the sale of bad products, to misrepresentation of these products, and to increasing risk. Country competition in the implementation of EU regulations and possibly in supervisory practices also had an impact.
The vagueness of the EU definition of depositary liabilities and the explicit reliance of UCITS on country regulations mean that in the European Union country regulations in the fund industry can be understood by legal origins more than by EU law. French financial civil law takes an administrative approach to depositary protection, an approach in which the depositary is an auxiliary to the regulator, whereas common-law culture relies on private contracts. The civil-law approach has influenced European financial regulations such as UCITS, in which depositaries play a central role in the protection of unit-holders. In the current reworking of depositary obligations, the French influence on EU law threatens depositaries with exorbitant liabilities; the temptation to rely on well-capitalised firms may also lead to consolidation in the fund industry.
To shield investors from non-financial risks, all parties can be required to hold regulatory capital against these risks; insuring non-financial risks can also be considered. The pricing of insurance and of risk-sensitive capital requirements must be based on a measure or “rating” of the non-financial risks. These ratings would shed more light on non-financial risks arising from sub-custody risk, from market infrastructures, and from investments in other funds or in derivatives on other assets, risks that are not adequately reported today. Last, governance can be improved by spelling out the responsibilities of the board and facilitating the intervention of unit-holders with class actions. The necessary improvements to risk management practices can then be driven by either regulatory bodies or industry groups.
The failure to improve the regulatory framework should imply a subset of “secure UCITS” in which depositaries would be unconditionally responsible for the restitution of assets. The necessary changes having been made, assets would involve, in the main, listed European financial securities admitted to central securities depositories systems.
This research was supported by CACEIS as part of the "Risk and Regulation in the European Fund Industry" research chair at EDHEC-Risk Institute.
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