Fund managers affected by the AIFMD (and even some that are not) are no longer disputing the merits of the regulation. Instead, they are embarked on a tight implementation schedule. One crucial decision is the appointment of a depositary bank to protect the investors in their funds. Ideally, the appointment of a depositary will leave their existing prime brokerage and fund administration relationships untouched. The global custodian banks that are the obvious candidates to play the role of depositary bank are no longer threatening to price themselves out of the market. They are however, demanding a high price in setting strict conditions for working with prime brokers and hedge fund administrators. If they get their way, managers will have to devote as much time and energy to asset safety as investment returns.
Perceptions of the Alternative Investment Fund Managers Directive (AIFMD) have shifted from the apocalyptic (the end of the hedge fund industry as we know it) to the visionary (the AIFMD-compliant fund will become a global brand comparable with UCITS). During this transitional stage, in which fund managers are preparing to comply with the provisions of the Directive ahead of its drop-dead implementation date of 22 July 2014, the mood is one of practicality and pragmatism rather than fear or resentment. Managers are understandably sensitive about some of the remuneration restrictions being considered by regulators. They are also daunted by the potential operational complexities of multiple reporting requirements to different regulatory regimes they will now have to adhere to. But the largest immediate challenge for fund managers is how to comply with the AIFMD requirement that they appoint a depositary to protect the interests of investors.
Article 21 of the AIFMD obliges fully compliant funds marketed by their managers to European Union (EU) investors to appoint a depositary to take on a range of responsibilities, all of them designed to protect the assets of those investors (see Table). The likeliest candidate to fulfil that role is a global custodian bank, partly because many managers are using one already to hold cash and unencumbered securities, but mainly because an Article 21 depositary takes on a balance sheet-eating liability to restore any assets which are lost or pay compensation in cash if they cannot be recovered. Projections of the costs charged by global custodians to assume this responsibility had narrowed from 30-40 basis points in 2012 to 15 basis points by this summer, to anywhere between zero (when purchased as part of a package of services from a universal bank) and no more than three basis points this autumn. The September 2011 warning by industry lobbyists the Alternative Investment Management Association (AIMA) that depositary banking would impose a $6 billion annual tax on hedge fund managers affected is now widely regarded as alarmist.
That said, prices will obviously vary according to the riskiness of the assets held and markets invested, but most custodian bankers now concede low single digits in basis points as reasonable in major markets, rising to high double digits for the most exotic appetites – though (see the Table) depositaries are expected even by regulators to refuse to guarantee assets in places where safety measures cannot attain AIFMD standards. Nevertheless, there are a number of unresolved issues in the area of depositary banking, and progress in solving them needs to be made by 22 January 2014. This is the date set by the Financial Conduct Authority (FCA) - the United Kingdom regulator, which is so far the only one to translate the Directive into detailed regulations at the local market level – for submission of applications for authorisation as an AIFMD-compliant manager, if managers are seeking a guarantee of approval by the deadline of 22 July 2014.
The strict liability imposed on Article 21 depositary banks is a continuing source of tension between custodian banks and prime brokers in particular. This is because global custodian banks are loath to accept strict liability for assets that are not in custody with them, such as encumbered assets held at the prime broker, or within the sub-custody network of the prime broker. Custodians are haunted by the fact that in 2010 the French regulator and eventually the French courts required two global custodian banks - Société Générale and RBC Dexia - to make whole investors in a fund prime brokered by Lehman Brothers, which had re-hypothecated assets beyond hope of recovery. They suffered the impost despite the fact the assets were not in custody with them and the fund manager had agreed Lehman Brothers could re-use them. Naturally, custodians now believe they should be able to “discharge” their liability where assets held by third parties are lost. The AIFMD allows them to do this provided they can demonstrate an “objective reason” why they were not responsible. Understandably unconvinced that the courts will give quarter to a large bank in the highly charged aftermath of a loss of assets, custodians would prefer that prime brokers indemnify them against this risk. Predictably, the prime brokers are seeking to escape that responsibility.
There is an operational dimension to this. AIFMD requires depositary banks to ensure the assets of investors are segregated, even at the level of the prime broker. “Under AIFMD it is necessary for all financial instruments held in custody by the prime broker on behalf of hedge funds and their investors to be fully segregated so that in the event of a prime broker defaulting, the depositary bank can easily obtain those assets without delay,” explains Bill Scrimgeour, global head of regulatory and industry affairs at HSBC Securities Services in London. Unfortunately, this is not how the business has traditionally worked. Both custodians and prime brokers have preferred to hold all client assets in omnibus accounts in their own name. This makes it operationally awkward for them to segregate or earmark assets belonging to particular investors.
Worse, fund managers that are not prepared to let their prime brokers re-hypothecate their assets pay higher prices to borrow cash and securities, because prime brokers rely on using those assets as collateral to raise the finance or stock borrowings they on-lend to the hedge fund manager. In the United States, Federal Reserve Regulation T (Reg T) and SEC Rule 15c3-3 limit the amount of the assets of a client which a prime broker can re-hypothecate to the equivalent of 140 per cent of the liability of the client to the prime broker [see COO magazine, issue 2, “How they fund what funds you”]. In many other markets, there are no such limits. In the United Kingdom in particular, as regulators as well as fund managers and investors found to their dismay during the collapse of Lehman Brothers, there is no cap of any kind.
While this lack of any constraint on re-hypothecation might be re-visited as European regulators continue their attempts to suppress the so-called “shadow banking” sector, the lack of restrictions on the practice in the United Kingdom is a cause for concern at all would-be AIFMD depositary banks. “While AIFMD depositaries could theoretically impose contractual limits on how much client collateral the prime brokers can re-hypothecate, we want to have proper oversight procedures in place so we have a clear line of sight on where assets are being held at the prime broker,” says Scrimgeour. “In addition, AIFMD depositaries are likely to require the prime broker to indemnify them from any losses except where depositaries can discharge their liability for such losses.” Certainly, the present stand-off between custodian banks and prime brokers looks unsustainable. As Tim Reucroft, a director at custody banking experts Thomas Murray Investor Data Services, points out, holding custodians to strict liability under AIFMD even if a prime broker rather than a custodian loses the assets represents a potential systemic risk of exactly the kind the regulators claim they are seeking to eliminate. “If a large-scale prime broker went under, it could easily take one or more depositary banks with it if strict liability is enforced,” he says.
The consensus is that prime brokers will eventually agree to indemnify custodians against responsibility for loss of assets in (or re-hypothecated from) prime brokerage accounts. What custodian banks are less likely to achieve is full transparency into exactly where the assets are held. Prime brokers are understandably reluctant to disclose details of their funding, trading and hedging activities in that way, to say nothing of their reluctance to change their operational procedures to accommodate the regulatory obligations of third party banks. An excessively bloody-minded approach on this issue could prompt some custodians to refuse to work with certain prime brokers, or terminate relationships with hedge fund clients that refuse to change a prime broker as a result. “As depositary we are liable for any loss of assets, so accordingly we must conduct thorough due diligence on all parties and service providers,” says Brendon Bambury, director for United Kingdom sales at KAS Bank in London. “If we are not happy with the controls and processes at those service providers, and if those processes are not aligned with our own, we shall be reluctant to act as a depositary to that manager unless improvements are implemented or providers are changed.” Some believe transparency is a point that prime brokers will concede more readily than indemnification. “The prime brokers will have to provide depositaries with information about the type of assets held and where those assets are held on a daily basis,” says Roger Fishwick, a director at Thomas Murray Investor Data Services. “I am confident the prime brokers will become more transparent, although I doubt they will go as far as giving custodians indemnification for assets lost.”
That remains to be seen, and will be determined shortly. A longer term threat to efficient working between depositary banks and prime brokers is pressure from a depositary bank on a hedge fund manager to change a prime broker. Replacing a prime broker on grounds of asset safety, rather than its contribution to investment performance, would represent a potentially awkward inversion of the traditional priorities. “We would hope that if a hedge fund used a prime broker, which did not meet our standards, we would advise them to switch to one we are more comfortable with,” says Shane Ralph, a director at State Street in Dublin. “We have thorough risk assessments and intense operational due diligence and we will be conducting rigorous checks on clients’ prime brokers. This is important given the amount of risk depositaries are going to be taking on.” If a fund manager refused to switch prime brokers, the depositary would have no option but to terminate its own relationship with the fund. This, in itself, presents significant challenges. “Regulators have not clarified what happens when a depositary terminates its relationship with a hedge fund,” says Frédéric Pérard, head of Luxembourg and offshore centres for BNP Paribas Securities Services, speaking at the Global Distribution Conference organised by the Association of the Luxembourg Fund Industry (ALFI) in Luxembourg in September this year. “That AIFM would struggle to find another depositary, so would we have to serve as depositary until they find one? Alternatively, that AIFM could be forced to liquidate its business as it would be in non-compliance with AIFMD, and we could potentially be sued by the manager or end-investors.”
Assets held at prime brokers are not the only one to worry would-be depositary banks. Prime brokers tend to hold fixed income assets at the International Central Securities Depositaries (ICSDs) - Clearstream and Euroclear – which in turn hold them through their own sub-custodian networks. There is no love lost between global custodian banks and ICSDS, and the banks are arguing that the choice of sub-custodian by an ICSD might pose a risk to a depositary bank. It is an issue which the longest standing critic of the strategies of the ICSDs, BNP Paribas Securities Services, feels particularly strongly about. “We are working with ICSDs to reach an agreement whereby, if a client of ours has securities at the ICSD, and those securities are sub-custodied to a financial institution in a high-risk market, we would like that ICSD to ensure they use our sub-custodian network in that market,” explains Frédéric Pérard of BNP Paribas Securities Services. “Take a long/short equity hedge fund transacting in exotic or high-risk stock in an emerging economy. We would be liable for any loss of assets incurred through the sub-custodian network of an ICSD, which is beyond our control. If we required the ICSD to use a sub-custodian in our network, that would give us a significant degree of comfort.” Brendon Bambury of KAS Bank agrees that obliging fund managers or third party custodians to switch assets into their network is an option. “We are urging AIFMs to use our sub-custodian network in higher risk markets,” he says. “There are a minority of sub-custodians in frontier markets, for example, that do not have an industry-recognised credit rating or are not connected to SWIFT, which are therefore unacceptable to us from a risk perspective.”
Commercial decisions of that kind are likely to be postponed to the post-implementation period. For now, expectations are high that the questions of indemnification and the wider issue of sub-custody risk can be resolved in time to meet the 22 January 2014 deadline set by the FCA. “I believe we are in a solid position to finalise sub-custodian agreements with the prime brokers over the next few weeks,” says Mark Mannion, head of business development and relationship management for Europe, the Middle East and Africa (EMEA) for alternative investment services, asset servicing, at The Bank of New York Mellon. “The discussions have been positive and I believe it will be business as usual. The Bank of New York Mellon was one of the early movers, and we have spoken extensively with our wide network of prime brokers. I am confident the issue of indemnification will be resolved shortly.” Others agree. “Pre-AIFMD, local regulation in Italy and Ireland required depositaries to appoint prime brokers as the global sub-custodian so we have expertise in supervising and monitoring the primes,” says Shane Ralph of State Street. “However, depositaries will now have strict liability for the loss of financial instruments held by their sub-custodians. Primes are looking primarily at two different models with depositaries – namely indemnification and discharge of liability. We have some AIFMD-registered clients and we have agreements with their prime brokers using the indemnity model, and I believe more prime brokers will accept our terms going forward.” In Ireland, the funds industry association has played a role in helping depositaries agree a solution with the prime brokers. “In Dublin, SuMi TRUST is a member of the Irish Funds Industry Association (IFIA), where we used to meet once per month to discuss industry issues, particularly AIFMD,” says David O’Keefe, a director at SuMi TRUST in Dublin. “Since last year, however, those meetings have been bi-weekly, to understand the implications and impact of the Directive. We as an industry here in Ireland have a good grasp of what is required to support our AIFM clients.”
Others remain pessimistic about finding a compromise between the entrenched positions of custodians and prime brokers. “The big dilemma remains the legal uncertainty about the scope of the depositary's ability to discharge its liability under AIFMD,” argues Bill Scrimgeour of HSBC. “I am not entirely confident a commercial agreement between the prime brokers and the depositaries on the allocation of risk for losses will be reached in good time.” If the legal uncertainty persists, there is a possibility that the European Securities and Markets Authority (ESMA) will intervene to impose an agreement. Scrimgeour says that, while he would like ESMA to settle the issue, he doubts it will happen. “I am not confident ESMA will intervene,” he continues. “Any agreement between the prime brokers and depositaries will be a purely commercial decision and I do not think ESMA will want to get involved.” The worst case scenario is that the differences of view are settled in a courtroom on the basis of litigation following a loss of assets. Jean Devambez, head of products and client solutions in asset and fund services at BNP Paribas Securities Services in Paris, thinks this is a real possibility. “As things stand, it will be a judge that decides who is liable for any loss of assets between the depositary bank, prime broker and ICSD if things continue the way they are,” he says. Judging by the Lehman Brothers International precedent, relying on the courts to determine liability in the event of loss could consign investors to exactly the type of multi-year delay AIFMD was designed to avoid.
Ironic outcomes are not, of course, unknown in the area of financial regulation. But, for managers, court cases lasting years to allocate liability for lost assets is an even less attractive prospect that being invited by a depositary bank to change a prime broker. So they will want to choose their depositary banks carefully, and make a thorough assessment of how they intend to work with prime brokers, and other sub-custodians. Indeed, they are obliged to do this under the AIFMD, which stipulates that managers must be able to prove that they have conducted thorough due diligence on the depositaries they choose, and that they continue to monitor them for any potential failings. This requirement has found its way into the variation of permission documentation issued by the FCA to fund managers wanting to manage alternative investment funds (AIFs) under the AIFMD. Managers expecting to rely on the SAS 70 certification of a depositary are being advised it is not enough.Roger Fishwick of Thomas Murray Investor Data Services says his firm is offering a depositary monitoring tool that draws on the experience of monitoring global custodian banks on behalf of institutional investors. “Managers that choose not to outsource the monitoring of their depositary banks will have to find some means to ensure the systems and processes used by their depositaries meet the standards set by the AIFMD,” he warns. “This obligation to ensure they meet the standards set by the directive starts at the point of selecting a depositary and continues thereafter. The appointment of a depositary is a requirement for obtaining a licence to manage an AIF.
However, full compliance is something many – indeed, probably most – hedge fund managers based in Europe can postpone. Non-EU hedge funds marketing to EU investors, such as Cayman-domiciled funds managed from London, are able under Article 36 of AIFMD to continue to use private placement. The private placement rules are uncertain, since they are set at the level of the member-state rather than the EU as a whole, but they do offer many managers an opportunity to at least pause before purchasing a full depositary service. In essence, non-EU managers selling or wanting to sell to EU investors by private placement can adopt a so-called “depositary lite” arrangement by which the depositary is responsible for monitoring of cash flows (essentially, subscriptions and redemptions, plus any other cash movements), safekeeping of assets (which can continue to be done by the prime broker) and oversight of service providers (including the fund administrator calculating the NAVs, as well as the prime broker)
Demonstrably, it offers managers the opportunity to persist with their existing arrangements, subject only to the appointment of a third party to oversee those arrangements, for there is no requirement to have a single depositary performing all three of these functions. Article 36 therefore allows prime brokers to act as safekeepers of assets just as they do today, while managers will not have to pay a depositary to replicate the work already carried out by the prime brokers and fund administrators. In fact, the only new requirement is that some entity provide “oversight” of the kind traditionally performed in the mutual fund industry by the trustee. Importantly, “depositary lite” is cheaper too, since strict liability for loss of assets does not apply to a “lite” depositary. Provided the oversight function is separated “functionally and hierarchically,” the third party role can even be performed by an existing service provider. Plenty of fund administrators, fearful of losing control of relationships with managers that are clients already, are queuing up to do it.
In fact, “depositary lite” has provided a lifeline to stand-alone hedge fund administrators lacking a bank-sized balance sheet, or a banking licence, which is required to act as a full depositary under AIFMD. Some stand-alone administrators have contacted global custodians with offers to form partnerships, in which the custodian banks would provide the safekeeping services. But custodians are wary of being held liable for mistakes made by third party administrators, and not disposed to help competitors anyway, particularly if it adds risk to their business. So most administrators are going it alone, setting up a “depositary lite” service that they believe will enable them to retain relationships without having to struggle to convince managers they could make investors whole for loss of assets. Several of the larger stand-alone fund administrators are now seeking regulatory approval from the FCA to launch just such a depositary function.
SS&C GlobeOp is one of them, and hopes to have regulatory approval no later than early January 2014, in time to service managers submitting their variation of permission applications to the FCA. Its depositary will be structured as a separate subsidiary. “The stated objective of setting up a depo-lite is to minimise cost and disruption to our clients hoping to run AIFMs,” says Des Pierce, director for strategic markets at SS&C GlobeOp. “By setting up a depo-lite, it will enable our clients to avoid the duplication of other service providers having to re-perform the work we can offer. Our depo-lite will be a separate legal entity which is functionally and hierarchically separate. It will have an independent team and technology infrastructure, and it will operate independently of SS&C GlobeOp’s administration entities.” But it is not just established fund administrators establishing “depositary lites.” INDOS Financial, an independent depositary providing oversight functions established by former hedge fund chief operating officer, Bill Prew, is currently in the final stages of obtaining regulatory approval.
There are challenges ahead for fund administrators offering “depositary lite” services. The most obvious is whether a subsidiary is truly independent. If the depositary spotted an error at the fund administration arm of the same business, what guarantees are there that the error will be reported? Banks have argued for years that they have robust Chinese walls in place without convincing anyone they are impermeable. If large banks are unconvincing on this point, stand-alone fund administrators will struggle to convince investors, managers and regulators that their own arrangements are more robust. Another issue confronting “depositary lites” is their lack of balance sheet strength and track record in custodying assets. Even if they are not ensnared by the strict liability provisions of AIFMD, that is scarcely a selling point to investors, and it does not in any event exempt them from liability for negligence. As a number of fund administrators have found, fines for negligence can be substantial enough to threaten the viability of a business. Banks and investment banks may have fragile funding, but they are widely believed to be better placed to withstand a substantial financial shock. It is for reasons of this kind that investors and managers are likely to favour a brand-name bank - including the fund administration arm of a bank or investment bank to perform “depositary lite” services - over a thinly capitalised fund administrator.
“These administrators do not have substantial balance sheets and they can still be liable for non-performance or errors in their oversight role,” says Bill Scrimgeour. Peter Townsend, head of hedge fund solutions at BNP Paribas Securities Services, endorses this view. “This could present a challenge for smaller firms offering these services,” he says. “While we believe the depo-lite model with stand-alone administrators will appeal to certain managers, there are risks. These firms may not have strict liability but that does not excuse them from litigation, and if an aggrieved party took them to court, this could be a challenge to their business.” Banks argue they can provide a “depositary lite” service in addition to a full depositary service, and back both with a much stronger balance sheet than a stand-alone administrator. Bank of New York Mellon already offers a “depositary lite” service in addition to its fully fledged depositary offering. “We can offer a depo-lite service to non-EU hedge funds wanting to use the private placement regime and we can provide a one-stop shop service,” says Mark Mannion. His counterpart at BNP Paribas Securities Services, Peter Townsend, agrees, but is more cautious. “Depositary banks can opt to offer depo-lite services to non-EU funds,” he says. “However, depo-lite as a concept is in its infancy and we are offering it cautiously.”
“Depositary lite” providers counter that they have sufficient protections in place to guard against the financial shocks of litigation for negligence, and even claim that they carry less risk on their books than the average bank. “We have not received questions from investors or clients about our balance sheet,” says Des Pierce of SS&C GlobeOp. “But we are not a small business – we are a $3 billion market cap company. Granted, we cannot compare our balance sheet to that of an investment bank, but we are by no means small. As an independent firm, we are not subject to the risks of cross-contamination that can affect a bank. Furthermore, we will have insurance coverage to mitigate any such risks.” One London-based hedge fund COO agrees that indemnity insurance provides adequate protection. “A lot of these depo-lites have insurance and that should help mitigate the possibility of liability risk damaging the overall business,” he says. Indeed, the counterparty risks of employing a single bank to carry out depositary duties, fund administration and prime brokerage exposes managers to catastrophe if that bank fails. Dividing functions between service providers could reduce the counterparty risk and, more importantly, make it much easier to port assets to another provider in the event of a failure. “It should be appreciated that changing fund administrator can be a lengthy process,” warns O’Keefe.
So, unfortunately, is the FCA approval process, and time is not on the side of the “depositary lites.” The FCA deadline for submission of a VOP document to guarantee authorisation as an AIFM of 22 January 2014 is a full six months ahead of the final deadline of 22 July 2014. Yet those permissions depend on having a depositary in place. So if the FCA finds a “depositary lite” unsatisfactory for any reason, it could put the entire authorisation process at risk, and leave insufficient time to put it right by 22 July 2014. “If the entire depositary situation remains uncertain, it could be an issue when filing the variation of permission,” says a COO at a London-based hedge fund. One possibility is to identify the depositary but acknowledge it is still awaiting FCA approval, but that is scarcely a satisfactory answer. There is also a risk ESMA could come out against the entire concept of “depositary lite” when the AIFMD is up for review in 2015. (The industry is now resigned to AIFMD II and AIFMD III.) Mark Mannion of BNY Mellon suspects ESMA will require non-EU hedge funds to subscribe to a full depositary service, rendering “depositary lite” obsolete in less than two years’ time, further inhibiting the appetite to adopt it.
Custodians, of course, have every reason to make that argument. They may be proved right. For now, however, the absence of a clear regulatory stance gives hope to “depositary lite” providers. “In 2015, non-EU managers of non-EU funds can apply for a passport, but that will mean they need to appoint a full depositary,” explains Peter Townsend of BNP Paribas Securities Services. “ESMA's expected 2015 decision on the future of private placement rules will likely dictate the future of the depo-lite regime.” Shane Ralph of State Street agrees. “We do not know exactly what ESMA is going to do other than look at aspects contained in the Directive, so I am unsure whether the depo-lite issue will fall under review,” he says. “We shall just have to wait and see.” Whether managers pondering appointment of a “depositary lite” will be content to wait and see for another year or two, or go for full depositary arrangements now, will be known in a matter of weeks, as the rush to secure FCA approval gathers pace ahead of the 22 January deadline. The likeliest outcome is that some will be, and some will not be.
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