Over the last decade, the UCITS (Undertakings for Collective Investments in Transferable Securities) product has enjoyed tremendous success globally. Within Europe, the growth of UCITS has been fueled in part by not only product innovation but the introduction of the Euro in 1999. In the face of the potential disintegration of the Euro in the midst of a sovereign debt crisis in one or more European countries, management and boards of UCITS should consider a variety of potential risks and scenarios as part of an effective risk management program. This DechertOnPoint will highlight certain key considerations for UCITS in evaluating and planning for a potential complete or partial break-up of the European Monetary Union (Eurozone).
UCITS Risk Management
Overview of the Risk Management Process
The UCITS Directive establishes the obligation for the home Member State of a UCITS to require UCITS to have adequate procedures and internal control mechanisms in place, including with respect to principles for the measurement and management of risks associated with positions in derivatives. Generally, UCITS are required to implement a documented risk management process that is designed to identify and manage material risks to which UCITS are exposed in relation to the performance of the activity of collective portfolio management. Recent market events and the pending uncertainty with the Eurozone have emphasized the need for a comprehensive review of UCITS risk management procedures to identify and manage all materials risks.
Risks Relating to a Potential Eurozone Crisis
There are a number of direct and indirect risks arising from a potential Eurozone crisis. Because of the changing parameters of the Eurozone crisis, the list below is not intended to be exhaustive. Moreover, as events unfold, a fund's risk management efforts need to be ongoing and responsive to changing develop-ments. Following is a discussion of some of the most significant risks at the current time.
Direct and Indirect Exposure on UCITS Portfolio
Eurozone Sovereign Issuers
The most direct investment risk that a UCITS can face is where a fund holds a debt security from sovereign issuers that suffer downgrades or defaults. This direct exposure should be easy to quantify, although there are differing, and changing, views of the risks of certain European sovereign issuers, such as Italy. A fund's holding of a derivative instrument directly exposed to a sovereign issuer (such as a credit default swap) should also be consi-dered when evaluating direct investment exposure. UCITS managers should begin to review their portfolio holdings to quantify and evaluate their direct exposure to sovereign debt. In such cases, these investment exposures should generally be reported to, and discussed with, the UCITS board or the board of the management company.
Indirect Exposure to the Eurozone
A UCITS' potential investment exposure is obviously not limited to direct holdings of sovereign debt. A number of large financial institutions, particularly in Europe, are known to have large exposure to the sovereign debt of Greece and other troubled countries. The financial institution's exposure can be both direct (holding sovereign debt) or indirect through derivatives. Other types of issuers may also have substantial exposure to the Eurozone. In contrast to direct...