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Non-Financial Risks, Regulation and Innovations

Risk and Regulation in the European Fund Management Industry

A former research chair on "Risk and Regulation in the European Fund Management Industry" at EDHEC-Risk Institute supported by CACEIS, analysed the major risks faced by the main actors in the European fund management industry due to their practices and the regulations, measured the importance of those risks and their impact on the actors’ solvency and business models, and proposed rules and solutions to enable the risk of the actors in the fund management industry to be limited.


The financial crisis has had some unprecedented consequences for the fund management industry.

Up until now, financial crises only had negative consequences on the revenues of industry players by affecting the volume of assets managed on behalf of investors, with the latter being alone in bearing the risks of their investment. The most recent crisis has impacted not only the revenues, but also the operating expenses of third-party asset managers.

The fund management firms and their service providers have had to take on some of the costs relating to the risks of the investments that they manage, keep under custody, price or audit. More specifically, this crisis is synonymous with a transfer of a portion of investor risk towards the providers of investment and related services.

This transfer is the result of two phenomena.

The first is related to the reputation risk that has led a significant number of fund management companies, either alone or with the support of their major shareholder, to assume some of the cost of liquidity risk for open-end funds invested in assets that soon became impossible to trade or were traded at valuations that were unacceptable for funds that are sometimes presented as treasury management instruments.

Even though the legislative texts and the regulators were not forcing fund management firms to take on this risk, one is obliged to observe that the desire of the latter to preserve their reputation and protect both the assets managed and the associated revenues led them to take on considerable costs for this risk. This same reputation risk, and sometimes a legal threat calling into question the quality of their work in the area of selecting hedge funds, has also led companies that manage funds of hedge funds to compensate victims of the Madoff fraud.

The second phenomenon is the application of texts and regulations whose consequences for service providers had not been truly taken into account until now. This is notably the case of texts that bring a large number of responsibilities to bear on the custodian, including the obligation to return assets, which was emblematic during the Lehman and Madoff collapses of the risk that it represents for service providers. The custodian’s business model is based more on volume than on margins, and as a result they have to hold a considerable amount of assets to be returned. They consequently face potentially significant risk. This second phenomenon is all the more important in that market regulators have tended to consider that good risk control for third party fund management was based on separation/segregation of the activities and, often, the actors, and on the existence of a solvent actor as a last resort. This solid actor was seen as being the custodian, who is covered by the extensive regulation of bank status, and as such seems more solid than the fund management firms, notably when the latter are not part of a banking or insurance group that is governed by demanding prudential regulations.

In the end, both the domestic European regulators and the European Commission, who wish to avoid increasing the cost of investment management and reducing the amount of competition by requiring significant capital of fund management firms, have continually transferred risk towards service providers who were not directly involved in the act of management which is, paradoxically, the source of the risk. The calendar of European reforms relating to the crisis, and notably the difficulties that third-party fund management has experienced in the areas of asset security, pricing and compliance with regulation, leads one to believe that this shift in the responsibilities of all the actors in the fund management industry is a durable one that will have a significant impact on the profit and loss accounts of not only the fund management firms, but also of all the service providers who are associated with them.

For EDHEC-Risk Institute, it is clear that the reasoning that involved saying that the main economic risk facing the fund management industry was the fall in revenues and that led the regulator to require fund management companies to hold an amount of capital that was intended for operating expenses, will give way to the integration of risk based on volumes, the complexity of the assets and operations, and the legal and contractual obligations of each of the participants in the industry’s value chain.

Research Papers

The following papers were published as part of this research:

Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry
December 2012
Noël Amenc, Frédéric Ducoulombier
In the current paper we conclude three years of research on better management of non-financial risks within the European fund management industry and put forward a series of proposals to limit these risks which emerged during the 2007-2008 crisis and undermined the quality of the UCITS label. It is our fervent hope that the three key recommendations we make, on the reinforcement of information on non-financial risks, increased responsibility of all actors within the fund management industry, and the creation of a new label of “Restricted UCITS,” be adopted by the industry so as to restore the reputation of the UCITS brand to its previously hard-earned and rightful place.

Shedding Light on Non-Financial Risks – a European Survey
January 2012
Noël Amenc, François Cocquemas, Samuel Sender
This survey analyses the views of European fund industry professionals on non-financial risk and performance in a changing regulatory framework. It analyses the risks those in the industry face as a result of regulation and of their practices, assesses their importance and impact in terms of solvency and business models, and proposes methods to attenuate them. The survey is based on replies from 163 high-level professionals of diverse horizons from the European fund management industry. The results show that at the top of the list of concerns are transparency, information and governance, followed by the financial responsibility of the fund management industry. The survey also covers themes such as restitution and depositary liabilities, distribution and judicial powers of investors.

The European Fund Management Industry Needs a Better Grasp of Non-financial Risks
December 2010
Noël Amenc, Samuel Sender
This publication looks at how non-financial risks and failures have impacted the regulatory agenda in Europe and traces the management of liquidity, counterparty, compliance, misinformation, and other financial risks in the fund industry. By identifying the distribution of risks and responsibilities in the industry, it examines how convergence between country regulations could be achieved. Finally, it assesses how fund unit-holders can best be protected with appropriate regulations, improved risk management practices, and greater transparency.

Are Hedge-Fund UCITS the Cure-All?
March 2010
Noël Amenc, Samuel Sender
As part of the CACEIS research chair on non-financial risks in investment funds, EDHEC surveyed UCITS and alternative asset managers, their service providers, external observers, and investors for their views of structuring hedge fund strategies as UCITS. The 437 respondents report assets under management (AUM) of more than €13 trillion. Investment fund managers account for roughly €7 trillion of these assets. In general, the survey suggests that institutional investors bound by quantitative restrictions will ask fund managers and distributors to repackage hedge fund strategies as UCITS. For their part, managers of alternative funds are concerned by the uncertainties surrounding the directive on alternative investment fund managers (AIFMs) and may consider packaging their strategies as UCITS. Most respondents, however, fear that structuring hedge fund strategies as UCITS will distort strategies and diminish returns.

Related Research Papers

Response to ESMA Consultation Paper to Implementing Measures for the AIFMD
September 2011
Noël Amenc, Samuel Sender
Several regulatory initiatives are being taken in Europe and recommendations that will reshape the investment fund industry are being made. Existing regulations, such as UCITS, are being reshaped; the need for a regulation of depositaries has been acknowledged, and since the G20 there has been more focus on the monitoring of hedge funds. Many of these regulatory needs have converged in the alternative investment fund managers’ directive (AIFMD), which means that the AIFMD could become a unique framework that settles most of the questions related to the common framework for funds, fund managers and depositaries. However, it must avoid the risk of the AIFMD not being applicable if it appears as a patchwork of diverging goals that have been grouped into a single directive solely for political reasons. The present position paper addresses the measures for implementation of the AIFMD.