May 2013

EDHEC RESEARCH: The dangers of Ucits

RobberyGreater regulatory harmonisation is needed to strengthen the Ucits regime, say Noël Amenc and Frédéric Ducoulombier at Edhec-Risk Institute.

Following on from our recent article (Funds Europe, March 2013) which looked at ways in which the Ucits brand image could be improved, we discuss the causal factors in the rise of non-financial risks in the European fund management industry.

In research conducted in the context of the chair endowed by Caceis, we analysed the rise of non-financial risks in the fund industry and contended that their main causes were the expansion of eligible assets and authorised techniques combined with inadequate regulation and supervision.

Ucits regulation was originally modelled on country regulations at a time when funds invested mainly in domestic listed securities, which made it particularly easy for depositaries to hold the bulk of assets in custody. While the scope of Ucits-eligible investments and authorised techniques has been expanded with a view to keeping up with financial innovation in competitive international markets, provisions on depositaries have essentially remained unchanged for over a quarter of century.

Regulatory and supervisory competition between countries in their implementation of the Ucits framework has been facilitated by gaps or vagueness of some terms in European regulation and by the proportionality and subsidiarity principles at the heart of the European project. The latter is illustrated by the reliance on directives which, in contrast to immediately applicable regulations, need to be transposed into Member State laws, which opens the door to incomplete, selective, or partial application of European regulation.

Gaps and ambiguities in European fund management regulation affect some of the core elements of the framework. For example, the Ucits definitions of eligible assets leave room for interpretation. With some Member State regulators electing to clarify definitions with their own lists of eligible assets or eligibility criteria and others remaining silent, asset menus vary with jurisdiction.

Likewise, under the current Ucits framework, the meaning of safe-keeping is not defined, there is no list of assets that are expected to be held in custody, the duties of a depositary with respect to the selection and oversight of sub-custodians are unclear, and liability in case of loss of assets under custody is expressly left for each Member State to define.

These unclear liabilities mean it is difficult for depositaries to ascertain the extent to which they need to perform due diligence and exercise oversight and to charge fund managers for additional verifications not clearly expressed in regulations.

Perhaps unsurprisingly, non-binding recommendations have proven a weak tool for convergence.

Differences in efforts applied by supervisory authorities towards uncovering breaches of regulation and variations in sanctioning regimes are likely to lead to unequal levels of compliance and, therefore, different levels of market integrity and investor protection. These also open the door to supervisory arbitrage detrimental to the establishment of a level playing field across the European Union. As things stand, differences in the resources of supervisors, in their administrative and enforcement powers, in the criteria they use to arrive at a decision, in the pecuniary sanctions they can impose with respect to different categories of breaches, and in their use of sanctions is bewildering. There is also variety with respect to civil and criminal liabilities for wrongdoing.

Differing implementation of EU laws and differing supervisory and sanctioning cultures have created dangerous cross-country heterogeneity and opportunities for jurisdictional arbitrage, which are conducive to the growth of non-financial risks.

Regulatory certification reduces the incentives for investors to perform effective due diligence on the actual risks of products and may exacerbate adverse selection and moral hazard phenomena, whose mitigation should be a major and ongoing preoccupation for regulators, thereby increasing risks in the fund management industry.

Adverse selection may arise when certification can be obtained by complying with the letter of the law but without truly restricting the fund’s investment strategy or protecting investors; this is particularly worrying in the retail landscape as non-professional investors often lack the resources to exert due diligence and make informed decisions. A case in point is the French dynamic money market fund segment whereby the regulator certified as highly liquid funds that were invested in potentially illiquid assets.

Moral hazard may arise as investors or the fund management industry, on the basis of certification, take more risk with the expectation of being bailed out by the regulator and its parent should risk materialise. Inadequate prescriptions and misleading certifications also contribute to mis-selling and poor risk management (when regulators’ assurances are taken at face value and risks are neglected).

A majority of respondents to our survey agree that inadequate regulation and supervision played an instrumental role in the rise of non-financial risks in the industry: 58% of respondents consider that the lack of harmonisation of rules was an important or very important factor (and only 14% that it was irrelevant), and 57% blame inadequate and/or unclear regulation (11% judge it irrelevant).

Not only has the regulation in place proven to be ill-suited to prevent or manage the non-financial risks arising from the changes in the investment fund industry, but it has also facilitated the growth of these risks by creating opportunities for jurisdictional arbitrage and reinforcing moral hazard through the promotion of certification over transparency.

Regulatory initiatives follow crises with a lag and are crippled by backward-looking biases that make them poor instruments in terms of preventing future calamities. It is necessary to make the management of non-financial risks an integral part of risk management as a piecemeal approach to prudential regulation is bound to fail – specific predictions are bound to fail and blind spots are unavoidable. In the wake of the global financial crisis, the role of the regulator has grown to titanic or heroic proportions since its ambitions are nothing short of protecting humanity against risk. We consider this a manifestation of hubris and recognise in the constant recurrence of crisis the fates of Prometheus and Sisyphus. We trust a more modest approach to regulation is warranted, which will focus on incentives to proper risk management and transparency. In this approach, the central role of regulation is to promote investor awareness to risks and to provide them with the tools – and notably transparency – they need to discharge their due diligence responsibilities.

Noël Amenc is director at EDHEC-Risk Institute, and Frédéric Ducoulombier is director at EDHEC-Risk Institute – Asia

©2013 funds europe