July-August 2012

ASSET SERVICING: Risky business

The costs of alternative funds could rise under new depository laws. Funds Europe asks custody banks which types of funds are likely to be affected. Edited by Nick Fitzpatrick.

The risks in the custody banking business are expected to shoot up under the Alternative Investment Fund Managers (Aifm) directive. The final announcement on this regulation is due soon, with implementation next year, but the text is now as good as set.

Custody banks, through their depository functions, are expected to virtually insure the assets held within clients’ Aifm-covered funds by being held liable for their loss. For some time, banks have said this could mean greater costs passed on to fund managers and investors as they seek more compensation for the risks.

We asked a range of custody banks which type of funds may be affected and how the banks’ greater liability will affect collateral arrangements, which has also been caught up in
the regulation.

STATE STREET
Keith Burman, senior managing director of private equity and real estate services, Luxembourg and Ireland

Which types of funds are the most risky to provide services to from a depository perspective?

The biggest individual risks for depositories will be the custody of financial instruments in markets where the local sub-custodians and/or local market infrastructure are less robust. For example, in emerging markets, or where the financial instruments are new or unusual in some way.

The most substantial risks, in aggregate, will be in those markets where the greatest value of securities is held in custody.

Do you anticipate depositories will increase fees for these funds?

It seems inevitable that banks will have to reserve additional capital in order to remain in the depository business. This suggests that depositories will face a number of difficult choices. Options include either exiting the business; reducing market and investment coverage to reduce the most significant risk areas; or increasing fees to cover the additional operational oversight and capital costs that will arise.

How is the Aifm directive likely to impact collateral services and with what results for depositories?

Depositories are likely to scrutinise carefully any arrangements which give a counterparty day-to-day control of collateral. This may require collateral holders to be appointed as sub-custodians of the depository, or to provide significant contractual safeguards and indemnities.

DEUTSCHE BANK
Mike Hughes, head of alternative fund services, Emea & Asia

Which types of funds are the most risky to provide services to from a depository perspective?

It’s not necessarily a case of which funds are the most risky but which specific assets and in which markets the fund wants to invest. From a depository liability perspective, the level of oversight with financial assets is the greatest risk. We can expect to see depositories looking to limit their exposures by reducing the chain of sub-custodians in favour of a bank that can custody assets though its network.

Do you anticipate depositories will increase fees for these funds?

This is likely. Higher costs are expected for managers and investors where the agent appointed by the depository is not in its core network or within its own organisation.

The third-party risk has to be priced into the holding fees.

How is the Aifm directive likely to impact collateral services and with what results for depositories?

The key will be safeguarding the assets when they are not held in the name of the fund and the view taken (principally a credit view) on the counterparty who is taking the collateral. In the case of a re-registration of the assets out of the alternative investment fund, there is no issue. However, if the assets remain in the name of the fund and rehypothecated, this will require depositories to undertake a detailed risk analysis on the chain of intermediaries. It is anticipated that depositories will have a pre-approved list of counterparties/collateral takers but there will be an increased level of due diligence on those counterparties.

BNP PARIBAS SS
Chris Adams, head of hedge fund solutions

Which types of funds are the most risky to provide services to from a depository perspective?

It is not the assets themselves that create the risk – rather how and where they are safe kept. Therefore, under the likely Aifm directive liability regime, any ‘In Bank’ assets that are not in the depository’s own network increase the risk. An extensive proprietary network is critical in this respect. Strategies that trade high security volumes, or for which there is significant volatility in terms of the amount of collateral required, will present challenges.

Do you anticipate depositories will increase fees for these funds?

There will be upward pressure on fees, caused by increased levels of due diligence and control required, and by the liability regime. However, the impact will be mitigated by a revision of the interactions between prime broker and depository, and by the funds’ use of depositories’ collateral management, asset protection and independent over-the-counter valuation services.

How is the Aifm directive likely to impact collateral services and with what results for depositories?

Collateral management will become key to depositories’ control of the hedge funds’ assets. Depositories will have to have sophisticated multi-asset class collateral management capabilities, primarily on a bilateral basis.

JP MORGAN WSS
David Kane, head of trust and fiduciary and compliance reporting

Which types of funds are the most risky to provide services to from a depository perspective?

Types include previously unregulated hedge funds and private equity funds. Hedge fund managers may choose to have assets held via a prime broker or a collateral agent, requiring additional depository controls.

Do you anticipate depositories will increase fees for these funds?

Depositories are being required to perform new tasks, such as verification of ownership, which will require additional resources. They are being asked to take on new risks, which will have capital and resource implications. These will raise fees, but at levels to be determined.

How is the Aifm directive likely to impact collateral services and with what results for depositories?

Collateral will need to be treated as a custody asset, so long as the fund retains an interest. That is a new arrangement, and it is being left to the industry to work out how brokers and others can fit into the chain of custody. The uncertainty left by the legislation is challenging for all.

CITI
Natalie Westerbarkey, director, securities and fund services

Which types of funds are the most risky to provide services to from a depository perspective?

It is not the specific types that would make providing depot-bank services more risky, but the way the depository liability has been enshrined into law with the Aifm directive. It was believed that an investment theme into emerging markets could be considered more risky. However, recent events in developed markets showed that the new liability rules will impact the asset safekeeping business in any jurisdiction.
 
Do you anticipate depositories will increase fees for these funds?

The depot banking industry will need to assess changes in their business risk profile and how to potentially mitigate these, including through an increase of fees. The answer depends very much on the depot bank’s client base, the volume, types and locations of where the assets are held in custody, plus other services provided to the client.

How is the Aifm directive likely to impact collateral services and with what results for depositories?

Collateral aspects will be most relevant in the context of leveraging arrangements and Level 2 is expected to provide further detail. Regarding depot banks, it is under discussion whether a third party should be appointed to act as collateral keeper and regulators suggest this being the prime broker. However, this would expose the depository to such party’s negligence, errors or fraud.

RBC DEXIA IS
Jean-Michel Loehr, chief industry and government relations

Which types of funds are the most risky to provide services to from a depository perspective?

Risks will be greater in less mature markets where transfer of ownership and end custody cannot be adequately guaranteed, or for shares in investments funds held with local transfer agents whose selection was not within the remit of the depository.
 
Do you anticipate depositories will increase fees for these funds?

There will be a substantial cost for additional risks and due diligence processes, part of which will find its way to the end clients. How much depends on depositories finalising their individual impact and risk assessments.

How is the Aifm directive likely to impact collateral services and with what results for depositories?

The current proposal implicitly encourages depositories to keep on their own books collateral received or granted by the alternative investment fund (AIF), except for title transfer collateralised assets. The option to appoint a broker holding AIF collateral as a sub-custodian does not reflect the current model, and the prospect of creating such a model seems unlikely to be workable. Moreover, the appointment of a third party to act as collateral keeper would expose the depository to such party’s negligence, errors or fraud.

UBS GLOBAL FUND SERVICES
Pierre-Antoine Boulat, head of fund services Luxembourg

Which types of funds are the most risky to provide services to from a depository perspective?

I won’t be a surprise to see that assets held away like derivatives, over-the-counter derivatives or hard assets, securities and cash entrusted to faraway countries’ sub-custodians, where settlement and ownership certification mechanisms are less advanced than in traditional markets, are riskier.



Do you anticipate depositories will increase fees for these funds?

When commoditised services revert back to higher value offering, such as insurance, assumption of risk and provider selection and monitoring, compensation has to increase to rebalance the risk/reward profile.



How is the Aifm directive likely to impact collateral services and with what results for depositories?

The impact will greatly depend  on the qualification of collateral as custodied assets or not. More transparency of collateral movements and holdings in many directions will be required.

BNY MELLON IS
David Aldrich, managing director

Which types of funds are the most risky to provide services to from a depository perspective?

Funds investing in frontier markets, where insolvency law relating to assets held for clients in custody is either less advanced or perhaps even absent, provide the most significant issues for depositories under the proposed regulation, as depositories could be held liable. For example, for third-party fraud related losses that trigger the restitution obligation.

Do you anticipate depositories will increase fees for these funds?

The costs of providing depository services are very significantly increased by the Aifm directive, especially in two areas – the increased costs of delivering the functional requirements of the directive itself. For example, additional supervisory, due diligence and process functions, and also in respect of the liability for losses outside of the direct control of the depository.  These costs will ultimately be borne by investors into these funds through higher fees, which equate precisely to lower returns. The directive is clear and prescriptive on responsibilities and roles of parties involved. Therefore, it will not be possible for investors into collective investment schemes to avoid these costs.
 
How is the Aifm directive likely to impact collateral services and with what results for depositories?

The Aifm directive is prescriptive on the degree of control that the depository must have over collateral owned by the fund. This will have an impact directly on the types of margin and collateral arrangements that funds will be able to enter into.  The precise details will be worked out between the counterparties, the fund and the depository in the period between the publication of Level 2 technical standards and the implementation date.

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