What keeps Luxembourg up at night?
With the current volatility in the markets you would expect that fund managers have enough to concern them without considering the risks associated with the safekeeping of their funds’ assets. Even an apparently unrelated financial failure of one of their post-trade counterparties may lead either to a loss in value of assets, or pitch funds into prolonged and expensive litigation.
It is, therefore, essential that funds choose the counterparties that hold their assets carefully and pay continuous attention to where, how and on what terms the assets they are responsible for are held. It could, otherwise, prove a costly oversight.
Thomas Murray Data Services hosted a roundtable discussion in Luxembourg to bring together management companies and depositary banks to share concerns and exchange ideas about post-trade risk. A poll of the delegates found that 67 per cent were very concerned about their post-trade counterparty risks and 72 per cent believed that if one of their post-trade counterparties were to fail, the risk of the loss of assets would be extremely high.
Figure 1. Types of risk exposures faced by Management Companies
The risk exposures faced by the industry are extensive and diverse, taking risk management functions beyond the traditional scope of market risk. It is not surprising that these risks have been receiving more attention in recent years as the regulatory pressures have evolved in the wake of the financial crises. The implementation of UCITS V, the CSSF circular 11/512 and AIFMD have called for enhanced measures to limit operational and counterparty risk and have increased liability if such failures were to occur.
Responsibility lies with the management company, driving their need to be meticulous in their due diligence processes. If they are found to be in breach of their UCITS obligations they could be fined up to EUR 5 million, 10 per cent of their annual turnover or, alternatively, at least twice the amount of the benefit gained from the infringement, where this is determinable.
Conducting Officers can also be held personally responsible and could face a permanent or temporary ban from fund management, suspension of authorisation, criminal sanctions and a personal EUR 5 million fine.
One wonders how anyone is willing to take on this responsibility.
These enhanced obligations have spurred the International Organisation of Securities Commissions (IOSCO) to update its 1996 advice to fund managers on the safekeeping of assets. The eight standards provide a comprehensive summary of how fund managers should ensure assets are kept safely. They should choose a regulated and independent custodian through a careful due diligence process, document the liability of the custodian in detail, disclose those details to investors, insist their assets are segregated at every level in the asset holding chain and monitor their custodian continuously.
Fund managers accustomed to investing in markets purely on the basis of the availability of a reputable custodian and a reliable clearing and settlement infrastructure need to take into account jurisdictional risk as well. The poll revealed that management companies believed their greatest risk exposures were with local market sub-custodian banks, transfer agents and fund distributors.
Figure 2. Degrees of Risk Exposures faced by Management Companies and Investors
Investors and management companies (via the funds that they invest in or manage respectively) are exposed to both direct and indirect post-trade counterparty and market infrastructure risks. Exposure to direct counterparty risks occur through arrangements with global custodians/ICSDs, central counterparties, prime brokers and transfer agents. Indirect post-trade counterparty and market infrastructure risks include exposure to markets, central securities depositories (CSDs) and sub-custodians.
Some of these risks are negotiable and some are not, however, even non-negotiable risk can sometimes be mitigated with effective monitoring. The board of directors of the management company is ultimately responsible for ensuring that adequate procedures are in place to manage and measure risk. The regulations demand a resident Luxembourg conducting officer whose primary role is devoted to risk management. ALFI publishes a detailed outline of the role whose responsibilities must include:
It is not surprising, therefore, that management companies in Luxembourg have had to expand their operations and employ more resources in order to meet their risk obligations. The regulations have, for the most part, succeeded in avoiding ‘letter-box’ entities by issuing stringent demands on management companies. Particularly when you consider the complexity of the expansive network of counterparties that a management company could have:
The diagram above provides an indication of a management company's potential network. Those in blue could be functions performed in-house but they could also be outsourced to third parties depending on the structure and resources of the management company. The conducting officer in charge of risk, however, is still ultimately responsible for monitoring each function.
Considering the extensive range of internal and external functions, management companies must take the utmost care when selecting and supervising these. Consequently, for each function, the management company may have thousands of different counterparties to monitor which amplifies the risks to which it is exposed. This was raised at the the workshop in Luxembourg and, as a result, the findings revealed that the due diligence processes implemented by management companies were not yet automated. Fewer than 40 per cent perform on-site visits to their counterparties, which is surprising considering the extent of liability applicable to the management company and its conducting officers.