Noël Amenc and Frédéric Ducoulombier explain the Edhec-Risk Institute's recent proposal to create a new Ucits category.
Applying the onerous restitution liability standards of the draft Ucits V Directive across the Ucits universe would result in significant costs and opportunity costs for investors. Also, communication around the obligation of restitution may mislead non-professional investors into believing they will always be protected against the non-financial components of investment risk, which will not be the case. For example, acts of nature. Last but not least, the absence of contractual discharge for the liability of the depositary in Ucits V creates adverse selection and moral hazard issues at the expense of depositaries and soundness of the industry.
Against this backdrop, in recent research supported by Caceis, Edhed-Risk Institute has put forward a proposal for a major upgrade of the European fund management industry. The proposal is to create a subcategory of Ucits structured to avoid exposure to non-financial risks by construction. Named “restricted Ucits”, it would be meant for retail investors.
This proposal addresses the observation that with the evolution of the Ucits framework, the label is applied to funds that are exposed to widely different levels of non-financial risks.
Our recommendation is to align the liability regime of Ucits depositaries with that of the Alternative Investment Fund Managers Directive (AIFMD), and simultaneously encourage the creation of a subset of Ucits that would be covered by an unconditional guarantee of restitution, with relief limited to narrow force majeure situations.
The objective is to reduce non-financial risks to an absolute minimum within a subset of the Ucits universe by restricting assets and practices that are inherently risky.
Naturally, depositary institutions offering such extended guarantees of restitution would need to be subjected to specific prudential requirements, lest moral hazard and systemic risk be increased by the operations of aggressive or less than honest providers, which could capture market share by offering guaranteed low costs, foster a race to the bottom, and go bankrupt when risk materialises.
The depositary of a restricted Ucits would have a fiduciary duty vis-à-vis the fund’s investors and guarantee the unconditional restitution of assets lost as a result of the materialisation of non-financial risk, with narrow exceptions, such as acts of nature and failures such as the default of a central counterparty (CCP).
This obligation and its framework would arise from a legal definition by the regulator, including significant restrictions on eligible assets and practices.
Safety does not come cheap. However, we are not suggesting that non-professional investors be restricted to this segment, but instead are making the case for transparency on non-financial risks and enhanced incentives to mitigate these risks across the Ucits universe and for developing a segment of the Ucits space where investors are insulated against these risks to the highest degree possible.
IMPACT ON DISTRIBUTION
Ucits have become synonymous with a high degree of investor protection worldwide and a significant share of the growth of Ucits now happens outside the EU, 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 the respondents to a recent Edhec-Risk survey agreed that such a label would confuse the definition of Ucits funds and thus be detrimental to the brand.
It is probable that the use of the word “secure” should be avoided as it may 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 can have ruinous 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 and the Eligible Assets Directive (EAD), there have been concerns about complexity and opacity in some realms. The alternative investment industry’s taste for embracing the Ucits wrapper to offer funds (nicknamed Newcits) fuelled fears that retail investors could gain access to complex product via Ucits. 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 address the need for retail investor protection while preserving access to a wide spectrum of funds.
In this context, our proposal would allow the diverse needs and expectations of regulators in the EU and third-party jurisdictions to be met with respect to the balance between financial innovation, regulatory oversight, and investor protection.
ROLE OF THE DEPOSITARY
While our proposal entrusts the depositary with a fiduciary duty vis-à-vis the fund’s investors and subjects it to a strict liability of unconditional restitution, it does not require the depositary to carry the burden of non-financial risks on its own.
Not only must the depositary adopt best practices for the mitigation of non-financial risks, it must also design contracts with the other links in the chain – notably the fund manager and its sub-custodians – to align interests towards the prevention of non-financial risks and support the latter with adequate processes. The depositary’s negotiating power naturally depends on the competitive environment. From an adverse selection and moral hazard point, it would be unhealthy for depositaries to compete on the unconditional restitution obligation; this is why we limit it to the restricted Ucits category.
SCOPE OF RESTRICTED UCITS
For the depositary to be in a position to guarantee unconditional restitution, it must reduce risk to a very low level. Given the extreme nature of the non-financial risks of key relevance and the practical difficulty associated with their assessment, a conservative approach is preferable.
While the depositary will adhere to the highest standards for the management of non-financial risks, it will also need to exclude certain assets, techniques, structures, jurisdictions, and counterparties.
Assets carrying counterparty risk and all transactions giving rise to counterparty risk and not secured by CCPs would be off-limits: structured products and notes, certificates and depositary receipts, funds that are not restricted Ucits themselves, over the counter derivatives and efficient portfolio management operations would be prohibited.
Other assets that cannot be held in custody would be excluded. For example, assets that cannot be physically delivered to the depositary or are not registered or held in an account in the name of the depositary; investments in privately-held companies and interests in partnerships.
Transactions that take place in jurisdictions that do not adequately protect property rights and/or would require the use of market infrastructures that are not compliant with recognised standards.
In practice, the bulk of European funds are invested in areas where the legal and market infrastructures are robust; a transition towards restricted Ucits would primarily require them to exclude assets and transactions that give rise to counterparty risk that is not dealt with by CCPs and assets that cannot be held in custody.
Noël Amenc is a director at the Edhec-Risk Institute and Frédéric Ducoulombier is a director at the Edhec-Risk Institute – Asia
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