The misdirected directive?

Asset management


German asset managers got their first glimpse of the new rules that will revolutionise risk management in the industry at the end of November last year. Barely two months later, the rules came into force. Today, some German asset managers talk about the introduction of the directive as though they were recalling a particularly brutal mugging. “We had little time to react, BaFin was very strong, and our lobbying was not successful,” says Joachim Hein, head of risk control at asset manager Union Investment in Frankfurt. The rules, known in Germany as the ‘Derivateverordnung’ or ‘DerivateV’, are part of a comprehensive overhaul of the country’s investment laws, which will eventually consist of 14 separate directives. The domestic legislative schedule is one reason for the time pressure that forced Germany’s financial regulator BaFin to rush DerivateV through consultation. Another is reform at the European level, where the European Commission (EC) has called for more sophisticated risk management requirements to be brought into effect in a response to the growing complexity of some investment products.

Germany is the first of the major European countries to react to the EC recommendations by drafting its own domestic rules – but the German fund management industry is now struggling to cope with a directive that critics claim is unnecessarily complex and overly prescriptive.

Despite these complaints, all new funds launched this year will have to be compliant with the rules – while full compliance is required for many companies by the start of 2006. There are more pointed accusations, too – that BaFin, under government pressure to ratify the rules, simply copied and pasted sections from banking industry rules on managing derivatives market risk; that the regulator lacks the in-house expertise to police the directive; and that BaFin officials have privately admitted the rules are just a stop-gap and may have to be changed.


Whatever the truth of these charges (see box for BaFin’s response), it’s clear that sections of the industry are on the back foot. “The industry was astonished by the directive, because the requirements for more ambitious funds are very heavy and will require huge investments. At the same time, there is cost-cutting pressure so people now feel they can’t fulfil the whole of the directive as it stands,” says Sven Zeller, a partner at law firm Clifford Chance in Frankfurt.

Union Investment has been working on a project to bring its risk management capabilities into line with those required by the directive since the end of 2003, and expects to complete the work at the end of this year.

Wolfgang Mansfeld, one of the company’s board members, says around 20 people have been working almost full-time on the project, which will mean an implementation bill of up to €2 million. Operating the new systems after implementation will leave Union with an annual bill of between €2.5 million and €3 million in added costs, he says.

The extra running costs come principally from the intensive calculations required by the directive. For the first time, funds will be able to invest in the new wave of structured investment products and use a wider range of over-the-counter derivatives to hedge their exposure. Funds that choose to do so will be subject to what DerivateV calls the ‘qualified approach’ to risk management (while funds who stick with more traditional investments and hedges will use the ‘simple approach’).

Under the qualified approach, asset managers must satisfy a series of market risk management strictures very similar to those that have been standard practice in the banking industry for the last decade – there is an absolute risk limit that restricts any fund to 200% of the risk exposure of a simple, benchmark fund.

Compliance is assessed using value-at-risk models, the integrity of which is monitored through daily back tests and monthly stress tests. Almost all this will be new for most asset managers and, says Union Investment’s Hein, it is “unnecessarily onerous”.

While banks trade in and out of derivatives positions on an intra-day basis, resulting in measurable shifts in their books when the markets close, asset managers are far more likely to hold their positions – for them, it makes more sense to measure risk and performance over weeks or months.

That is how the critics’ argument goes, but not everyone sees it that way. Ralf Rausch, Frankfurt-based head of risk and control at DWS Investments, Deutsche Bank’s asset management arm, sees the opportunity to invest in new derivatives products as a huge opportunity – and also claims that BaFin has chosen a perfectly appropriate framework to measure the risks involved.

As a former auditor of proprietary trading books with Deutsche’s corporate and investment banking division, he has seen risk management in his current industry from both sides of a trade, and asserts that asset managers’ hedges are “simply the other half of a bank’s proprietary book. The risk is the same. The way it reacts to market movements is the same”.

More importantly, he says, the institutional buyers of DWS’s funds are pressing for the company to use more up-to-date products. “They all want better performance with less risk, and we can now start offering that to them. It represents a sea change for German asset management – but with it goes the requirement to measure and manage the risk carefully.”

So, is the carping about DerivateV just another example of industry trying to take opportunities with one hand, and hold back regulation with the other?

“There may be a bit of bluster there,” says Andrew Aziz, vice-president of buy-side solutions at Algorithmics in Toronto. “But, at the same time, it seems that the rules could shut down some business in the industry, which is ironic, given that the aim was to put in place a more permissive environment for derivatives use.”

Some asset managers privately admit that attempting to ensure compliance with the directive has forced them to hold off on the development of new funds. Clifford Chance’s Zeller says it has become common practice for German asset managers to avoid compliance for new hedge funds (which, he notes, are not expressly mentioned in the new directive, but “obviously” fall under its aegis) by launching funds in Luxembourg, where they are registered with the local supervisors, then importing them for public distribution in Germany. Currently, he says, only two hedge funds exist that operate under German regulations.

The theoretical underpinning for DerivateV has recently been put under the microscope by a paper written by Lutz Johanning (holder of a professorship in asset management at the European Business School) and his colleague, Sebastian Werner, in June. Broadly, it offers support for critics of the directive.

DerivateV calls for VAR to be reported at a 99% confidence level (meaning losses are expected to exceed limits on one day in every 100) over a 10-day holding period. Johanning argues that it would make sense to apply a 95% confidence level (where losses exceed limits on one day in 20) over a 60-day holding period.

As the directive stands, he says, BaFin is effectively taking tools and practices from a short-term trading environment, and applying them to an environment with a much longer time horizon. He worries that the outcome will be to produce conflicting incentives, in which asset managers are pressured to produce investment returns over months and years, while managing risk over periods of days and weeks.

As well as these fundamental concerns, industry critics also see devils in the detail of the new regime. Union Investment’s Hein is particularly incensed by what he calls “the reverse stress test”. Under the terms of the rules, not only do asset managers have to examine how the fund behaves under stressed market conditions, they also have to work out what conditions would result in the total loss of the fund – a requirement he describes as “bizarre”.

“Normally, you have an idea of the market variation and then you calculate the value of the fund,” says Hein. “In the reverse test, you start with the fund at zero and work out what market variations could cause it. Even today, we’re not sure what the point of this exercise is.”


The industry hasn’t given up hope of persuading BaFin to amend the rules, but while the arguments rumble on, Germany’s experience of acting on the EC recommendations has raised questions for the rest of Europe. Other countries will be expected to pass regulations that bring their own industries into line with the EC stance, but there is a certain amount of leeway on how to interpret that stance.

A proliferation of different market risk strictures would clearly not be a good thing for a European market that has set its sights on closer integration and more cross-border sales and marketing.

If, for example, the German regulator thought the Italian approach to market risk management was too lax, it might be moved to bar the distribution of Italian funds in Germany – a danger flagged by Union Investment’s Mansfeld. “There is no indication yet that this kind of thing will happen,” admits Mansfeld, “but the risk is there.”

BaFin’s response to criticism

BaFin, Germany’s financial regulator, declined to put an official forward for interview, but agreed to put criticisms of DerivateV to its principal authors and provide a written response.

The regulator says the process of drafting, reiterating and approving the directive had to happen quickly, because it was working to a timetable that required ratification no later than February this year. Moreover, it says the consultation period was not too short. “The industry’s input was very much appreciated and most wishes expressed by the industry in this process have been fulfilled.”

BaFin denies that DerivateV was a copy-and-paste job from the corresponding banking regulations, but admits that the sections relating to VAR methodology “have been modelled on the banking industry [because] they are common standards”.

Objections to the VAR methodology resulted in some dispute over the appropriate confidence level and holding period, but BaFin claims the industry did not “propose an alternative standard”. Instead, the regulator included a provision that allows asset managers to use different parameters “if it is appropriate for the risk profile of the funds under management”.

However, BaFin remains convinced that daily VAR calculation is necessary – whatever the turnover of the derivatives positions: “Even if the portfolio of a fund does not change on a daily basis, the markets do,” the regulator says.

BaFin maintains that it has enough staff to effectively regulate the industry under the directive, but declines to say how many staff within the asset management division have the skills required to monitor VAR systems, noting instead that “the asset management department co-operates with a special department within the BaFin where the relevant expertise is centralised”.

Finally, BaFin notes: “VAR measurement and stress tests are now European standard for the management of investment funds. Instead of seeing it as a burden, the industry should see it as a criterion of quality necessary to be competitive.”


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