Regulation And Risk Management-00-7354

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UCITS III has increased the role of middle office and has driven a flurry of new investments in risk management: in people, software and data services.

UCITS III has borrowed the notion of VaR from the sell-side industry and has introduced it in the asset management world where VaR was not at all central. UCITS III introduced in 2004 a distinction between Sophisticated and Non-Sophisticated funds and prescribed that the former use a VaR approach to risk management. The Non-Sophisticated funds were instead allowed to stick to the traditional commitment approach, measuring the exposure of the fund and controlling that the exposure is not higher than the double of the fund's NAV.

This distinction has been often used as a back-door to escape regulation avoiding the use of VaR and the prescriptions associated to it. An enlightening example lies in the many monetary funds that were heavily invested in ABSs: how many of those funds were declaring themselves as Sophisticated funds? Probably none of them as the Monetary classification clashes with the notion of sophistication. Unfortunately, we have all discovered at our ...
... expenses that ABSs were not a simple financial instrument.

However, the events of the credit crisis have pushed the European regulator to reconsider part of the regulation framework and enrich it. The UCITS IV Directive is expected to be voted on July 2010 and become effective at the beginning of 2011. This directive will drive all the investments in risk management in the buy-side industry in the coming years and will even have an impact on the hedge fund industry, as many hedge funds are creating UCITS vehicle to expand their commercial reach, benefiting of the regulation flexibility on leverage.

It is therefore important to highlight what parts of the coming regulation will impact future investments on risk management and pricing.

Sophisticated/Non-Sophisticated. The distinction will be abandoned and all UCITS will need to have a risk management process in place. UCITS will still be able to choose between commitment and VaR approach, but as the commitment approach becomes substantially more complex, the consensus seems to be that all the industry will move towards a VaR approach. Asset managers that today use only commitment approach will probably need to invest in VaR-based processes.

Mandatory Model Back-Testing. Model back-testing was a prescription only in some of the EU members. It will be extended to all Nations.

Liquidity Risk. This is the most important new prescription. The regulator will ask for a dedicated liquidity risk management process and for stress tests and scenario analysis on market liquidity risk. This prescription stems directly from the serious liquidity restrictions experienced by many monetary funds during the crisis.

Two Sources of Evaluation. While UCITS III already asks to have an independent source of evaluation in addition to the broker's quote for OTC derivatives, UCITS IV will extend the requirement to bonds that embed derivative pay-offs.

Consistency of Risk Management and Pricing. Another innovative prescription requires that the methodologies used for risk management and pricing are consistent. This does not mean necessarily that UCITS will need to use the same system for risk management and pricing, but simply that the models and methods used need to be compatible and built on similar grounds.

These prescriptions will drive the next investments in risk management and valuation and will further strengthen the middle office practices inside UCITS.

About the Author:

StatPro is a leading global provider of portfolio analytics, data solutions, asset pricing services and http://www.statpro.com/portfolio_analytics/middle_office_analytics/risk_management.aspx for the worldwide investment community. Founded in 1994, StatPro offers http://www.statpro.com/ software combined with pre-packaged evaluation services using the Software as a Service (SaaS) platform. The company's integrated solutions provide performance measurement, attribution analysis, risk management, governance, compliance and reporting - all in a single interface.