Professional Documents
Culture Documents
Management Version 06
September 2011
Forward 4
Create a SRPMO 5 Appendix I The 3LD Risk Management Model 19
Adjust Risk 6 Appendix II The ICAAP 20
Governance for Risk 7 Appendix III The SREP 21
ICAAP for Capital Uplift 9 Appendix IV The Scope of Risk Management 22
The Solvency II 10 Appendix V Solvency II, The 3 Pillars 23
Counterparty Risk 12 Appendix VI Client Assets (CASS) 24
Operational Risk 13 Appendix VII The UCTIS IV Directive 25
Regulatory Convergence 14 Appendix VIII The AIFM Directive 26
Business Model Adaptation 15 Appendix IX The Mifid II Regulation 27
Invest in People 16 Appendix X About Pytheas 30
ERM Systems & Controls 17
Forward
4
Create a SRPMO
5
Adjust Risk
Set the risk appetite to include more secondary and tertiary factors and
ensure that it is reviewed periodically according to the risk mandates of your
clients and results from ICAAP stress tests (see Appendix II, slide 20).
Companies
Asset managers should ensure that there is a clear and tangible articulation
of their companys tolerance for risk appetite to improve the granularity
should draw upon at
according to developing market practices in the industry. least five to seven
Companies should pay close attention to the direction their peer group is years worth of quality
heading, and be mindful that, eventually, they will be on the hook evidentially
for any documents that are published externally.
operational data for
Asset managers should also appropriately balance responsibilities between
their risk modeling and
the business and control functions such as risk, compliance and internal reverse testing needs
audit.
6
Governance for Risk
Set appropriate governance for investment risk that is consistent with the
companys risk appetite; involve risk as early in the product life cycle as
possible (see also Appendix IV, slide 22).
Companies
As part of industry leading practice, risk should be consulted as early in the
cycle of making all significant business decisions as possible, including those
should ensure
opening new funds, manufacturing new products or entering new markets. effective cross-linkage
Products should be brought to market as efficiently as possible without
companies feeling the need to rush particular processes. with risk appetite
Companies should apply particular care and due diligence to products that
statements and
are difficult to value, trade in a non-transparent fashion, or are not fungible.
They should consider setting the appropriate level of governance for
operational risk
investment risk and ensure effective cross-linkage with risk appetite management
statements and with operational risk management.
7
Governance for Risk
A scorecard or similar methodology for evaluating product pricing for all new
products and markets should be implemented by asset management
companies in order to ensure that risks are priced appropriately. Ideally, this
should extend to developing more of an Enterprise View for investment risk
with key investment indicators devised and socialized, with attribution
performed on a product-by-product level.
Product risk,
investment risk and
Given greater regulatory focus, companies should place higher weight on the
presence of evidence with OTC trades, or illiquid, complex or leveraged market risk are prime
products.
considerations for
Multiple and complex investment styles often adopted by asset managers
require the setting of appropriate governance for product risk, investment risk
Asset Managers
and market risk.
8
ICAAP for Capital Uplift
Use ICAAP procedures to optimize the amount of capital uplift needed (as
per Individual Capital Guidance), taking into account the need for robust
evidencing of reverse and normal stress testing (see Appendix II, slide 20).
Management of
Companies should carry out comparative studies on what competition is
doing as part of their ICAAP/SREP processes, bearing in mind the type and
capital will differentiate
combination of style factors that might give the regulator cause for awarding the winners from the
RMP points or setting elevated ICG uplifts. Revisit unwinding costs and fixed
overhead requirement amounts and define meaningful stress testing to losers in optimization,
destruction (killer scenarios). Ensure that your companys reverse stress-
testing scenarios draw upon at least five to seven years worth of quality
collateral management
operational data if possible. Risk governance arrangements in particular
should provide adequate levels of independent challenge, ideally free from
or seed capital
fund manager or business bias or conflicts of interest. They should be linked decision
to risk appetite and balance responsibilities between the business and
control functions such as risk, compliance and internal audit (see Appendix
III, slide 21).
9
The Solvency II
10
The Solvency II
In addition to sourcing data, asset managers should address issues around Under Solvency II,
data quality assurance and data governance to ensure they can demonstrate
the validity of any analysis. The issue of data storage and retrieval will also
Asset Managers who
need to be considered, particularly for firms outsourcing such components. are owned by insurers
Given the rapid onset of Solvency II, asset managers who are owned by should consider how
insurers should consider how to achieve increased look-through of asset
data and the ability to extract additional underlying information.
to achieve increased
look-through of
asset data
11
Counterparty Risk
12
Operational Risk
13
Regulatory Convergence
ESMA, the body overseeing the technical standards for UCITS, will require
seven levels of risk rating and calculation of the standard deviation of the
fund returns to be evidenced to clients and regulators alike.
Asset Managers
should consider
Traditional asset managers should not be complacent, as some of AIFM
Directives provisions will be used to back-fill the forthcoming UCITS V change with regulatory
regulations. The measures could also result in fewer intended consequences
for traditional firms managing real estate and investment trusts.
convergence in mind
14
Business Model Adaptation
Heads of risk should accelerate their dialogue with the business and
operations in terms of the potential impacts (both direct and indirect). It is
possible that cost increases could be passed back to the buy-side from extra
Transparency and
capital and collateral arrangements to support the clearing of standardized simplification is a must
asset classes at CCPs.
when it comes to
The notion of principles-based or market-led approaches to regulation is
giving way to a return to outcomes-based approaches and a desire for both
transacting
transparency and simplification when it comes to transacting.
15
Invest in People
A critical part of any companys remit must be to ensure that all members of
its risk team possess the necessary skills to fulfill their roles. However, as
The risk function
more attention must be diverted to administering governance, responding to needs to be
requests for information by regulators and facing up to board members,
NEDs and clients. The risk function needs to be anticipatory, acting more as anticipatory not merely
a partner in terms of keeping the business out of trouble, not merely policing
or reporting after the fact.
policing or reporting
Companies must invest in versatile individuals who can exercise seasoned
after the fact
judgment, not only on risk matters but also on compliance, legal, internal
audit, business, operations or finance matters.
16
ERM Systems & Controls
Companies should continue to design data taxonomies (e.g., a company- Companies should
wide consistent nomenclature behind specifying unique instrument or legal
entity identifiers) to develop master golden copy records and dashboard MI
devise an enterprise-
capable of tracking KPIs or KCIs. wide risk framework
Organizations should digitize documentation to support the desire for look- linked to risk appetite,
through and on-demand retrieval, strengthen ring-fencing against fraud and
integrate systems, controls and databases (particularly desktop systems
systems needs and
covering market or investment risk) more effectively with the rest of the
enterprise.
required management
processes
Companies should also take steps to devise an overarching enterprise-wide
risk framework linked to risk appetite, systems needs and required
management processes, plus a road map to drive the same.
17
The 3LD RM Model
19
The ICAAP
The ICAAP by the FSA is an important part of the process through which a firms Board or equivalent decision-making body is
informed of the ongoing assessment of the firm's risks, how the firm intends to mitigate those risks and how much current and
future capital is necessary having considered other mitigating factors. The ICAAP should therefore be owned and approved by
the firms board or equivalent decision-making body.
Medium and larger-sized LLIFs communicate the results of their ICAAP to the FSA by submitting a document which
summarizes the process the firm has gone through to determine the capital it deems necessary to hold (referred to hereafter as
the ICAAP submission). Through the submission of the FSA019 regulatory return, all LLIFs (including smaller ones) must give
us a quantitative high-level summary of their ICAAP each year. The ICAAP submission or regulatory return should be a
summary of the process the firm has gone through to assess the regulatory capital it should hold. A firms senior management
should, on an ongoing basis, satisfy themselves that the firm is, and remains, adequately capitalized. This also applies to
smaller LLIFs which, although they are not usually required to submit us a formal ICAAP (unless requested), should ensure that
they assess the level of capital they should hold on an ongoing basis in a manner which is appropriate to the nature, scale and
complexity of their business (Source: FSA).
See also: ICAAP submissions Observations for Limited License Investment Firms
Stress and Scenario Testing feedback on CP08/24
20
The SREP
As per Pillar 2 of the FSA, the Supervisory Board Process has two key elements:
Firms should have a process for ensuring that they hold capital consistent with their risk profile and strategy (the Internal
Capital Adequacy Assessment Process, or ICAAP); and
Supervisors should review that process and strategies and if they identify weaknesses or deficiencies should take
appropriate prudential measures, including the setting of a higher capital requirement (the Supervisory Review and
Evaluation Process or the SREP).
Through the SREP the FSA seeks to identify any weaknesses or inadequacies requiring a regulatory response in order to
provide the firm with:
Individual Capital Guidance (ICG) that reflects the amount of capital that the FSA believes is adequate for its risk profile,
strategy and capital resources;
Individual guidance reaffirming or amending any existing liquidity ratios, limits or behavioral concessions; and
Resultant prudential or other measures.
21
Scope of Risk Management
22
Solvency II Three Pillars
23
Client Assets (CASS)
The client asset specialist unit was specifically created by the FSA to provide confidence in the UK regulatory regimes ability to
deliver adequate protection of client money and safe custody assets (client assets).
The Client Asset Units mission is to help minimize the risk of financial loss from control failings and mitigate the damaging
effects of such potential failures on consumers, firms and the FSA.
See also: FSA Client Asset & Money Report (January 2010)
The Client Money & Asset Return (CMAR)
Developing effective resolution arrangements for investment banks (May 2009)
Source: FSA
24
The UCTIS IV Directive
The UCITS IV Directive is the fourth European Directive covering The five key changes built into the UCITS IV are:
Undertakings for Collective Investment in Transferable Securities (UCITS). Risk Diversification. No investment can exceed 10% of the
The aim was to establish a single regulatory regime across the European relevant UCITS funds NAV, with further restrictions such that
any fund would be required to have not less than 16 separate
Union for open-ended investment funds to invest in transferable securities investment holdings (the 5-10-40 rule).
(such as shares, bonds, etc.) to create wider investment and business
opportunities for investors and asset managers and to define high levels of Eligible Assets. UCITS IV had substantively widened the
eligibility criteria to include money market instruments, fund
investor protection. units, bank deposits and derivatives it being desirable that
UCITS [funds] should be permitted to invest in financial
instruments, other than transferable securities, which are
The UCITS project allows investment funds that fulfill the requirements of the sufficiently liquid.
UCITS Directive to be freely marketed, under the European passport,
throughout the European Union. The UCITS IV Directive offers certain non- Leverage. UCITS IV allows funds to borrow up to 10% of its
NAV on a temporary basis, allowing also synthetic leverage.
EU fund managers the opportunity to access the European markets without Restrictions on the global exposure to derivatives are limited to
being brought into the prospective AIFM Directive(Source: European the NAV of the fund with further restrictions on single
counterparties and permitted underlying assets.
Commission).
Liquidity. The UCITS framework requires that the units of any
See also: Directive 2009/65/EU of the European Parliament and of the particular UCITS fund must be redeemable not less than twice
a month. Also investors be allowed to redeem on short notice.
Council on UCTIS
25
The AIFM Directive
The European Commissions Directive on Alternative Investment Fund Managers (AIFM) regulates managers rather than funds,
although it has an impact on both. As per the directive only AIFMs established in the EU are able to provide their services and
sell their funds to investors in the bloc. Whether or not the fund is established in the EU does not matter, as long as the
manager running the fund is. In order to get permission to market their funds in the bloc, managers must be authorized by the
regulator in the EU country where they are established. Once a manager is authorized in one EU member state, he/she can sell
his/her funds throughout the EU. Managers based outside the bloc will be prohibited from marketing their funds in the EU,
unless they meet various fiscal and regulatory requirements. Managers based in the EU, who run funds established outside the
EU, are also subject to additional restrictions.
The Directive regulates all alternative investment managers in the bloc who are currently not covered by EU law, meaning that
a whole range of other fund managers such as those running real estate or commodity funds are regulated in addition to
hedge fund and private equity managers. AIFMs who manage less than 100 million of assets are exempted from the Directive.
For private equity, this applicability threshold is 500 million (Source: European Commission).
See also: Impact of the proposed AIFM Directive across Europe (October 2009)
Directive 2011/61/EU of the European Parliament and of the Council on AIFMs
26
The Mifid II Regulation
Mifid II (October 2011) is the key piece of regulation that is set to transform the way a range of instruments are traded in
Europe. It aims to update and build on the reforms introduced by the 2007 directive. Transparency is the central theme of the
Mifid rules and the European Commission is determined to ensure that the main rules around transparency in equities are
extended to other products too, including bonds, commodities, derivatives and structured finance.
The Commission plans to overhaul the European clearing market by forcing exchanges to allow clearing houses to access their
clearing flows. The rules will finally put an end to vertical silos whereby exchanges restrict access to their downstream
clearing houses thereby enabling them to dominate both the trading and clearing of instruments on their platform. The new
clearing rules will help aid competition in the derivatives industry by allowing upstart derivatives trading platforms access to
existing derivatives clearing pools that are vertically integrated. The rules will also force widely traded derivatives out of the
over-the-counter market and onto trading platforms. The European Commission has pushed ahead with a more stringent
version of its controversial proposal to create an additional trading category, an organized trading facility, in a bid to force OTC
trading into the light. Banks will not be able to put their own capital to work in the OTF category, which will make it very difficult
for investment banks, which use their own capital in a variety of ways throughout the business, to implement. Only ad hoc
trading of shares and other instruments will be allowed to take place off a platform.
27
The Mifid II Regulation
European efforts to regulate high speed trading will be covered by the Mifid regulation. The most controversial and confusing of
these is the requirement for firms to operate a continuous algo trading strategy during trading hours. This would imply that a
firm would have to continue to trade regardless of the prevailing market conditions. In the meantime, however, algo trading
firms will have to provide local regulators with a description of the nature of their algorithmic trading strategies once a year.
Despite much industry pressure, limits on commodities trading positions are to be enforced although these limits are unlikely to
be set in stone but rather subject to regulatory discretion. Regulators will have the power to limit the ability of an individual or
firm from taking over-large positions if they feel that doing so is damaging to the market. The Commission has allowed for the
creation of a commercial, rather than a mandated, trading tape of record. This will dismay many trading firms that are worried
that the commercial model will lead to multiple trading tapes thereby creating less, rather than more, market transparency and
keeping trading data prices high.
Much of the new texts will be referred to pan-European watchdog the European Securities and Markets Authority to implement.
ESMA will also be given the power to intervene in local markets to enforce the rules and ban certain products or practices. Mifid
will determine how share trading is to be suspended across Europe's trading venues. Earlier versions of the text had suggested
that a trading suspension on one platform ought to trigger a suspension on all platforms. This rule seems to have been refined,
however, and now appears to apply under specific conditions. It does not appear to apply in instances where technical
problems bring down a platform.
28
About Pytheas
30
Pytheas Main Services
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31
Pytheas Company Pulse
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Pytheas Investors Service
33
www.pytheas.net
Copyright 2011 Pytheas Limited
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