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Managing investment risks via regulation

Madhu Gayer
— 1 minute read

Increased regulation is changing how asset owners and managers understand and address investment risk, writes BNP Paribas Securities Services' Madhu Gayer.

Madhu Gayer

But for most of us, this does not mean that investment risk is ‘under control’.

One reason is that investment risk comes in many guises: issuer, credit, counterparty, country, volatility, liquidity, safekeeping, operational, and regulatory – to name a few.

New regulations aim to address the multiple types of risk faced by institutional investors today, but regulation cannot control those risks.

In the past, many asset owners, investment managers and advisers were not fully aware of the breadth of risks in the investment value chain.

For example, securities collateral was given (by way of security interest or even title transfer) to clearers, prime brokers, or international central securities depositories (CSDs) acting as tri-party collateral agents.

While regulators have always focused on risk, new regulations are far more comprehensive, explicit and prescriptive.

Regulators are demanding more transparency not just at the fund manager level, but also with end institutional investors.

For example, IORP II5 in its current proposed form will require pension schemes in Europe to produce a risk evaluation report covering a range of risks, including longevity, market, credit, liquidity and operational risk.

As such, pension schemes in the future may have to better articulate their approach to risk management. These developments will likely spread around the globe.

All of this has obvious benefits, not least increased transparency and asset safety.

However, taken by themselves, risk indicators, quantitative measures and risk reports cannot eliminate risk, but rather provide a framework to mitigate and manage acceptable risk.

Effective risk frameworks require, in addition to tangible outputs, the right intellectual and human capital inputs, aligned under the right governance framework.

Historically the depositary bank (or global custodian) was responsible for safekeeping.

Although advisers and consultants carefully considered the stability and reputation of the depositary as part of the selection process, the level of analysis did not always continue down to the quality of the sub-custodians, the prime brokers, or the derivatives clearers holding assets as collateral.

Safekeeping assets under a strict liability regime is now firmly the responsibility of the depositary.  

This new responsibility makes counterparty risk analysis much simpler for the institutional investor.

The focus of the discussion on asset safety has therefore shifted to the depositary’s risk management capabilities and financial stability.

We are also now increasingly seeing asset owners such as insurers, pension funds, central banks, and sovereign funds focusing on asset safety across the chain, to the extent that they now negotiate the same level of asset restitution liability from their global custodian as they would from a fund depositary.

Asset owners want the same level of protection for their direct assets and segregated mandates as that afforded to retail investors into regulated funds.

Regulation has and will continue to play a key part in managing risk. However risk management remains a ‘people business' where experience, instinct and a real end-to-end understanding of financial markets is key.

Therefore, we believe a cooperative approach is more important than ever in today’s changing world.

Madhu Gayer is head of investment reporting and performance Asia Pacific at BNP Paribas Securities Services.

 

Managing investment risks via regulation
Madhu Gayer
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