Risk Management for Asset Managers

Risk Management

Version 06

For Asset Managers September 2011 Author: Pytheas Strategic Advisory, Pytheas Asset Management & Harris A. Samaras

Copyright © 2011 Pytheas Limited

Contents Forward Create a SRPMO Adjust Risk Governance for Risk ICAAP for Capital Uplift The Solvency II Counterparty Risk Operational Risk Regulatory Convergence Business Model Adaptation Invest in People ERM Systems & Controls

4 5 6 7 9 10 12 13 14 15 16 17

Appendix I – Appendix II – Appendix III – Appendix IV – Appendix V – Appendix VI – Appendix VII – Appendix VIII – Appendix IX – Appendix X –

The 3LD Risk Management Model The ICAAP The SREP The Scope of Risk Management Solvency II, The 3 Pillars Client Assets (CASS) The UCTIS IV Directive The AIFM Directive The Mifid II Regulation About Pytheas

19 20 21 22 23 24 25 26 27 30

Forward Pytheas Asset Management is a leading asset manager for institutions, individuals and financial intermediaries, worldwide. We focus on global, regional, developed, and emerging markets, plus a number of specialty products, including country and sector funds. Our investments combine local resources with access to global strategies and networks, and we continue to offer new products in response to an evolving global market and our clients' evolving needs.

In keeping with the organization's "all-around relationship" approach, our risk management professionals cooperate intimately with the asset management, investment banking, industry experts and regional specialists to design risk management solutions that are most appropriate and effective given industry characteristics and geographic constraints and imperatives.

Risk Management should create value and be an integral part of organizational processes

This presentation brief highlights the continued evolution and strategic importance of the risk function for asset management companies.

4

Create a SRPMO Create a Strategic Risk PMO (SRPMO) to clarify business and operational impact for all risk functions.

Focusing risk management on the critical obstacles of protecting and growing the business in a measurable way gets risk onto the board’s and senior management’s agendas and focuses attention on material threats that can really hurt the business.

In today’s rapidly changing environment, companies should repurpose risk committees (or institute new committees) to concentrate on strategic and emerging risks in the business climate of each and every year to come. They should also ensure that the Three Lines of Defence Risk Management Model (see Appendix I, slide 19) is adhered to, with clear roles and responsibilities for the business and internal audit functions.

Companies must pay careful attention to setting and reviewing their risk appetite in a more dynamic manner

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).

Asset managers should ensure that there is a clear and tangible articulation of their company’s tolerance for risk appetite to improve the granularity according to developing market practices in the industry.

Companies should pay close attention to the direction their peer group is heading, and be mindful that, eventually, they will be on the hook evidentially for any documents that are published externally.

Asset managers should also appropriately balance responsibilities between the business and control functions such as risk, compliance and internal audit.

Companies should draw upon at least five to seven years’ worth of quality operational data for their risk modeling and reverse testing needs

6

Governance for Risk Set appropriate governance for investment risk that is consistent with the company’s risk appetite; involve risk as early in the product life cycle as possible (see also Appendix IV, slide 22).

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 opening new funds, manufacturing new products or entering new markets.

Products should be brought to market as efficiently as possible without companies feeling the need to rush particular processes.

Companies should apply particular care and due diligence to products that are difficult to value, trade in a non-transparent fashion, or are not fungible.

They should consider setting the appropriate level of governance for investment risk and ensure effective cross-linkage with risk appetite statements and with operational risk management.

Companies should ensure effective cross-linkage with risk appetite statements and 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.

Given greater regulatory focus, companies should place higher weight on the presence of evidence with OTC trades, or illiquid, complex or leveraged products.

Multiple and complex investment styles often adopted by asset managers require the setting of appropriate governance for product risk, investment risk and market risk.

Product risk, investment risk and market risk are prime considerations for Asset Managers

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).

Companies should carry out comparative studies on what competition is doing as part of their ICAAP/SREP processes, bearing in mind the type and combination of style factors that might give the regulator cause for awarding RMP points or setting elevated ICG uplifts. Revisit unwinding costs and fixed overhead requirement amounts and define meaningful stress testing to destruction (killer scenarios). Ensure that your company’s reverse stresstesting scenarios draw upon at least five to seven years’ worth of quality operational data if possible. Risk governance arrangements in particular should provide adequate levels of independent challenge, ideally free from fund manager or business bias or conflicts of interest. They should be linked to risk appetite and balance responsibilities between the business and control functions such as risk, compliance and internal audit (see Appendix III, slide 21).

Management of capital will differentiate the winners from the losers in optimization, collateral management or seed capital decision

9

The Solvency II The Solvency II principles-based regime takes effect from 2013; asset managers with insurance parents or clients will face more frequent and intensive requests for data for reporting purposes (see Appendix V – slide 23).

Solvency II represents a fundamental review of the capital adequacy regime for the European insurance industry. Not every asset manager will be affected by these measures, but those managers with insurer parents are being pressed to make changes to their systems, and companies with insurer clients may be faced with more data and reporting requests during the months ahead.

The data for Solvency II reporting will need to be captured and available to interrogate at short notice – the end-of-month or quarter-end cycle may not be sufficient.

Under Solvency II, the end-of-month or quarter-end cycle reporting may not be sufficient

10

The Solvency II Companies should consider how to achieve increased look-through of asset data and the ability to extract additional underlying information.

In addition to sourcing data, asset managers should address issues around 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 need to be considered, particularly for firms outsourcing such components.

Given the rapid onset of Solvency II, asset managers who are owned by insurers should consider how to achieve increased look-through of asset data and the ability to extract additional underlying information.

Under Solvency II, Asset Managers who are owned by insurers should consider how to achieve increased look-through of asset data

11

Counterparty Risk Asset managers should upgrade counterparty risk management systems to enable exposures to be determined by counterparty legal entity and by product on demand, ideally intraday.

Organizations should upgrade their counterparty risk management programs to enable them to pre-figure likely risk exposures on demand and to allow monitoring to be carried out by counterparty and asset class at will.

Companies should also revisit stock lending and collateral management processes, taking into account new regulatory developments such as the reintroduction of new short-selling restrictions and new rules around the handling of client assets e.g., revisions to the CASS rules per the FSA’s CP10/09 (see Appendix VI – slide 24). Newer regulatory measures, such as short-selling restrictions, UCITS IV (see Appendix VII – slide 25), the AIFM Directive (see Appendix VIII – slide 26), European Market Infrastructure Regulation on OTC derivatives and the proposed Mifid II measures (see Appendix IX – slides 27 and 28), might require more intelligent approaches toward mitigating the cost impacts and developing commercial opportunities.

New regulatory measures will require more intelligent approaches toward mitigating the cost impacts

12

Operational Risk Operational risk management needs to determine how regulation is affecting the adjacent domains, particularly outsourcing and delegation arrangements.

Managing operational risk used to be primarily about managing people, processes and systems. Given the drive toward greater degrees of complexity and expected performance, companies are encouraged to continuously check outsourcing and service level agreement arrangements with all third parties, especially if the company is actively managing money in emerging or frontier markets.

This is doubly important when relying upon third parties to value leveraged or non-transparent products such as interest rate swaps, credit default swaps, FX swaps/forwards, equity derivatives or inflation/climatic variables. This activity should include an audit of transfer agents, custodians, fund administrators and other ancillary functions.

Given the new regulatory measures risk and compliance management are converging for many Asset Managers

13

Regulatory Convergence Companies should complete preparations of KIID/SID documents under UCITS IV and tighten their risk framework arrangements around their SRRIs, while remaining vigilant on developments with the AIFM Directive.

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.

Traditional asset managers should not be complacent, as some of AIFM Directive’s provisions will be used to back-fill the forthcoming UCITS V regulations. The measures could also result in fewer intended consequences for traditional firms managing real estate and investment trusts.

Asset Managers should consider change with regulatory convergence in mind

14

Business Model Adaptation The European Market Infrastructure Regulation being introduced will have a significant impact on companies employing OTC derivatives for hedging or as part of their investment strategy.

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 capital and collateral arrangements to support the clearing of standardized asset classes at CCPs. 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 transparency and simplification when it comes to transacting.

Transparency and simplification is a must when it comes to transacting

15

Invest in People Up-skill resources, investing in people who demonstrate sound capabilities in regulatory policies and procedures, liaison with board members (including NEDs) and client facing work in particular.

A critical part of any company’s remit must be to ensure that all members of its risk team possess the necessary skills to fulfill their roles. However, as more attention must be diverted to administering governance, responding to requests for information by regulators and facing up to board members, NEDs and clients. The risk function needs to be anticipatory, acting more as a partner in terms of keeping the business out of trouble, not merely policing or reporting after the fact.

Companies must invest in versatile individuals who can exercise seasoned judgment, not only on risk matters but also on compliance, legal, internal audit, business, operations or finance matters.

The risk function needs to be anticipatory not merely policing or reporting after the fact

16

ERM Systems & Controls Develop ERM systems and controls, and reinforce workflow management, management information and data.

Companies should continue to design data taxonomies (e.g., a companywide consistent nomenclature behind specifying unique instrument or legal entity identifiers) to develop master “golden copy� records and dashboard MI capable of tracking KPIs or KCIs. Organizations should digitize documentation to support the desire for lookthrough and on-demand retrieval, strengthen ring-fencing against fraud and integrate systems, controls and databases (particularly desktop systems covering market or investment risk) more effectively with the rest of the enterprise.

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.

Companies should devise an enterprisewide risk framework linked to risk appetite, systems needs and required management processes

17

The 3LD RM Model

§ Promote a strong risk culture and sustainable riskreturn thinking § Portfolio optimization on the macro and micro level § Promote a strong culture of adhering to limits and managing risk exposure § Ongoing monitoring of positions and inherent risks

§ Combination of watchdog and trusted advisor; police limits with “teeth” § Understand how the business makes money – and actively challenge initiatives if appropriate § Top talent with business experience engaging with front office as equals § Risk management separate from risk control § Overarching “risk oversight unit” across all risk types § Intraday availability for data and positions; comprehensive report at T+1 6 a.m.

Audit

3rd Line of Defence

Risk Management Function

2nd Line of Defence

1st Line of Defence

Top Management & Front Office

§ Good understanding of capital markets, the business type, and risk management § Top talent within audit – to challenge the front office and risk management function § Independent oversight function – with enforcement ability (e.g., immediate fulfillment of findings) § Ability to link business and risk with process and IT know-how

19

The ICAAP The ICAAP by the FSA is an important part of the process through which a firm’s 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 firm’s 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 firm’s 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.

See also:

FSA – Our Pillar 2 assessment framework 21

Scope of Risk Management

The Scope of Risk Management

Ensuring that all aspects are considered, bound together by a common language for Corporate Governance, Risk Management, and Assurance, with common Processes, Culture and Business

22

Solvency II – Three Pillars

Pillar 1 Quantitative Requirements § Balance sheet evaluation § Solvency Capital Requirement (SCR) § Minimum Capital Requirement (MCR)

Pillar 2 Qualitative Requirements § System of Governance § Own Risk & Solvency Assessment (ORSA) § Supervisory Review Process

Pillar 3 Disclosure § Annual published solvency & financial condition report § Information provided to the supervisors § Link with IFRS 2

The Solvency II Directive has been drafted following the advice on Pillar I issues submitted by CEIOPS in March 2007. While the Directive has ‘Solvency’ in its title, it explicitly states that capital is not the only (or necessarily the best) way to mitigate failure. This is supported by recent CEIOPS studies of insurer failure and ‘near misses’ which found the primary causes of failure were poor management and inappropriate risk decisions, rather than capital inadequacy per se.

With this greater emphasis on risk management, the proposal compels (re)insurers to instigate governance and risk management functions and policies as the basis for ensuring adequate solvency continuously. The Directive stipulates that solvency capital calculations, whether based on the standard formula or an internal model, should be aligned to the specific risk profile of the undertaking. The standard formula categorizes risks into modules for capital purposes with an allowance for aggregation and diversification across the modules. An internal model would reflect a firm’s risk profile and management approach more precisely, and the sophisticated modeling of risk interactions is highly useful for ongoing management. However, this presents a more significant implementation challenge and will need regulator approval.

23

Client Assets (CASS) The client asset specialist unit was specifically created by the FSA to provide confidence in the UK regulatory regime’s ability to deliver adequate protection of client money and safe custody assets (client assets).

The Client Asset Unit’s 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. The Client Asset Unit has the following key objectives: § Improve client asset risk identification, assessment and mitigation § Increase firm compliance with the Client Asset Sourcebook (CASS) § Enhance our ability to react promptly to firm failure.

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 Undertakings for Collective Investment in Transferable Securities (UCITS).

The aim was to establish a single regulatory regime across the European Union for open-ended investment funds to invest in transferable securities (such as shares, bonds, etc.) to create wider investment and business opportunities for investors and asset managers and to define high levels of investor protection.

The UCITS project allows investment funds that fulfill the requirements of the UCITS Directive to be freely marketed, under the European passport, throughout the European Union. The UCITS IV Directive offers certain nonEU fund managers the opportunity to access the European markets without being brought into the prospective AIFM Directive(Source: European Commission).

See also:

Directive 2009/65/EU of the European Parliament and of the Council on UCTIS

The five key changes built into the UCITS IV are: Risk Diversification. No investment can exceed 10% of the relevant UCITS fund’s NAV, with further restrictions such that any fund would be required to have not less than 16 separate investment holdings (the “5-10-40 rule”).

Eligible Assets. UCITS IV had substantively widened the eligibility criteria to include money market instruments, fund 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 sufficiently liquid”.

Leverage. UCITS IV allows funds to borrow up to 10% of its NAV on a temporary basis, allowing also synthetic leverage.

Restrictions on the global exposure to derivatives are limited to the NAV of the fund with further restrictions on single counterparties and permitted underlying assets.

Liquidity. The UCITS framework requires that the units of any particular UCITS fund must be redeemable not less than twice a month. Also investors be allowed to redeem on short notice.

25

The AIFM Directive The European Commission’s 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 Like Pytheas, the ancient Greek explorer, scientist and businessman we provide access to markets inviting our partners to wander the paths and explore the places with a partner that possesses, knowledge of prevailing market dynamics, thorough industry expertise, and above all keen awareness of geographic idiosyncrasies‌ Pytheas is an organization with global outlook, offering a wide range of sophisticated financial services to companies, governments, institutions, and individuals.

Considered as one of the world's premier organizations in providing access to emerging financial markets and economies in transition, Pytheas services range from advising on corporate strategy and structure to raising equity and debt capital and managing complex investment portfolios.

Pytheas' investment management capabilities are among the best in the industry, offering a wide range of investment products and solutions for the investment issues faced by our clients throughout the world.

30

Pytheas Main Services Strategic Advisory

Business Development

Distress Management

Investment Management

Investment Banking Advisory

Corporate Finance

Capital Raising

Private Credit

Equity Finance

Risk Management

Credit Rating Guidance

M&A

Real Estate

Minerals & Mining

Emerging Markets Research

31

Pytheas – Company Pulse

Visit Pytheas Company Pulse

32

Pytheas Investors Service The Pytheas Investors Service was established as a vehicle for capital and investment to advise Pytheas’ clients on how to shape tomorrow’s business global map – to be a catalyst for growth, development and diversification by better positioning Pytheas’ clients in the global markets and in their quest for excellence.

In close cooperation with the rest of Pytheas’ professional network, it assists and guides clients to clearly identify and establish appropriate investment opportunities through in-depth research and analysis of the world's equities, industries, and markets.

Product experts, country specialists and industry analysts work in close unison and pool their talent to design, recommend, and, when appropriate, customize and fine-tune investment strategies that clients can act on in keeping with their portfolio preferences and imperatives.

The breadth and quality of Pytheas' fundamental research and strategic advice, combined with its in-depth industry knowledge and geographic specialization, offer investor clients a wealth of information to evaluate and prioritize their investment decisions.

33

www.pytheas.net

Copyright Š 2011 Pytheas Limited Disclaimer The above notes have been compiled to assist you; however, actions taken as a result of this document are at the discretion of the reader and not PYTHEAS.

All rights reserved. The material in this publication may not be copied, stored or transmitted without the prior permission of the publishers. Short extracts may be quoted, provided the source is fully acknowledged.