The depo-lite regime was supposed to be a quick and cost-effective method for non-EU hedge funds to comply with the AIFMD. As the deadline approaches Nicholas Pratt asks why there have been so few of these alternative depositaries created.
When the EU regulators behind the Alternative Investment Fund Managers Directive (AIFMD) devised the concept of a depositary-lite regime, it was designed to be a pragmatic, simple and cost-effective way for certain fund managers to meet the directive’s complex requirements.
Non-EU fund managers could continue to market their funds to EU investors via national private placement with a depo-lite depositary and would not need to meet the full depositary requirements of the AIFMD.
And, for certain service providers, especially independent fund administrators, there was an opportunity to set up this new type of depositary business with a minimum of fuss.
The critical point of depo-lite is that an appointed service provider would not face the strict liability for the loss of assets, thereby easing balance sheet concerns.
Specifically, under Article 36 of the AIFMD, non-EU managers marketing their alternative funds to European investors via various national private placement regimes, could use a depo-lite to meet just three of the depository duties set out under Article 21. Those are cash-flow monitoring, safekeeping duties for assets under custody, and oversight duties on unit creation, valuation and other instructions.
In January, INDOS Financial became the first independent UK depositary specialising in hedge funds to obtain authorisation from the Financial Conduct Authority (FCA) in the UK to act as an Article 36 custodian to provide AIFMD depositary-lite services. Significantly, this allows INDOS and its hedge fund clients to finalise their AIFMD arrangements ahead of the July 22, 2014, deadline.
SO FEW OTHERS
Given how close that date is, it is surprising there are so few organisations to have formally announced their intentions to become depo-lites, let alone obtain authorisation from the relevant jurisdiction.
According to INDOS founder and chief executive, Bill Prew, this may be partially down to the fact that the legal and regulatory framework for establishing a depo-lite outside the UK is not transparent.
This is particularly the case in Ireland, he says, where most hedge fund administrators are based and authorised. The Central Bank of Ireland (CBI) only announced in December 2013 that only the safekeeping of assets will be regulated. That’s to say just one of the three functions of a depot-lite.
There is, however, still confusion about whether all aspects of Article 21 safe keeping of assets require a custody authorisation.
Prew believes that Ireland is risking its reputation as a well regulated domicile in leaving the oversight function unregulated. This would hurt if, for example, there were another incident like the 2009 collapse of hedge fund Weavering Capital, where an unregulated affiliate of a fund administrator performing oversight has not performed oversight to the standard that would have been required if it had been a regulated activity.
Furthermore, Prew finds it hard to make sense of the CBI’s approach given that the whole point of the AIFMD is to provide more investor protection and that a depositary is performing a fiduciary function. “I think it may be that the CBI simply left it too late to bring in amendments to existing Irish regulations to regulate depositary-lite activities. Compare this to the position in the UK, where an entirely new framework has been established to regulate firms undertaking the depositary duties.”
So far only, one independent administrator, Centaur Fund Services, has formally announced plans to operate an unregulated depo-lite based in Ireland. Centaur Financial Limited (CFL) was established in November 2013. “Centaur feels that the most appropriate way of providing the new depo-lite services is via a completely separate, independent company in order to avoid conflicts of interest,” says Ronan Daly, chairman at Centaur Fund Services and one of two co-directors at CFL. “As such, CFL has been formed with its own staff, processes, procedures and independent board of directors.”
Kieran Fox, director of business development at the Irish Funds Industry Association (IFIA), says that the CBI has taken a sensible approach to depo-lite supervision. “The safe-keeping function is regulated and for the oversight function, the CBI must be informed in advance if it is new business and it must be in accordance with the Level II Directive.
“It will be a decision for the manager and the investor to decide on based on a range of factors including existing relationships and independence.”
Fox says he has not heard many managers voicing concern about depo-lites and expects to see more announcements in the coming six months. “Many are still in discussion with managers and are more focused on the full AIFM depositary regime and any additional issues have taken up their time for now,” says Fox.
“We expect to see a reasonable number of fund administrators provide this service as they finalise their discussions.”
Other independent fund administrators have chosen to seek authorisation in the UK for their depo-lites, such as SS&C GlobeOp. “We are using an existing regulated entity for custody under Article 36. We will be ready to offer that service by the end of the month, prior to getting full authorisation,” says Des Pierce, director for strategic markets at the firm. “We expect the majority [of clients] to be existing or brand new administration clients who find depo-lite to be the least disruptive model for AIFMD compliance.”
Another reason cited for the lack of depo-lite launches is that establishing one is proving to be less disruptive than first thought. Subsequent ESMA guidance about conflicts of interest and capacity concerns means that there is less difference now between the depo-lite and the full depository status and service providers are questioning the potential profitability on offer.
“Firms establishing a depo-lite need to look at their processes, get more basis points for the record-keeping services and limit their liability for the oversight service. But that is not something they can do overnight,” says Isadora Pardo, business implementation manager at software services firm Linedata.
“There will be more investment needed to ensure they have the right processes, the right staff, a separate company and separate systems – you cannot have the two entities sharing the same systems. There is also the reputational risk. You do not want an affiliated company performing oversight to be seen as having looser processes.”
There is also the uncertainty over how much of a short-term arrangement the depo-lite will be. If private placement is ended in 2015, then non-EU managers will need to apply for a passport to market their funds within the EU and this will require the appointment of a full depositary.
This is leading some depo-lite providers to more or less operate a full depositary service from the outset, esepecially given the connotations that the phrase ‘lite’ carries with it. “The word suggests that we are operating a less formal or less robust service. We prefer to refer to it as an offshore depositary service,” says Ian Headon, senior vice president at Northern Trust.
“There will be some legal and technical differences in terms of liability but operationally it will be to the same standard as a full depositary service. Because the depo-lite will have a short life span we would rather do the hard work now in making it effectively a full depositary service rather than have to take that step up at a later date.”
Headon accepts that Northern Trust’s approach will appeal to a certain type of manager whose investors have bought into the principle of investor protection at the heart of the AIFM. Other investors are almost resentful of being directed so prescriptively by European regulators and will seek the easiest and most cost-effective way to comply by the July deadline, worrying about the changes in 2015 and 2018 when those times come.
However, Headon has been surprised by the lack of investor engagement in the AIFMD in general, let alone the finer points of appointing a depo-lite. A client survey conducted at an event in December 2013 showed that even by December 2015 more than half of fund managers (54%) did not expect their investors to be engaged with AIFMD considerations and only 14% expected their investors to demand a fully AIFMD-compliant fund by then.
The issue for all providers and managers is that it is increasingly likely there will be a frenetic rush to the finish line for the July 22 deadline that is imminently avoidable.
According to Prew, the UK Treasury’s decision to allow an extended deadline for applications has led some managers to switch their focus elsewhere.
“We would like to on-board clients in good time in a controlled way, but I fear given the volumes of funds expected to seek to appoint depo-lites, unless managers make decisions soon and all providers quickly become operationally ready, the industry could see the opposite.”
©2014 funds europe