Singling out delegation of responsibilities as an outstanding issue, Luxembourg asset servicers outline the work completed – and still necessary – for them and their clients to make the Alternative Investment Fund Managers Directive fully operational.
Yvan de Laurentis (Head of depositary and fiduciary services, BNP Paribas SS)
Paul Faltz (Director, senior product manager, Citi)
Isabelle Goethals (Head of trust & depository service, HSBC SS Luxembourg)
Jean-Pierre Gomez (Head of regulatory & public affairs, SGSS)
Gaëlle Kerboeuf (Group general counsel, Caceis Group)
Brian McMahon (Managing director, BNY Mellon Luxembourg)
Paul Stillabower (Managing director, sales & distribution development, RBC Investor and Treasury Services)
Funds Europe: Following the implementation of the Alternative Investment Fund Managers Directive (AIFMD), what has gone well and what has gone less well?
Jean-Pierre Gomez, Societe Generale: We cannot compare across jurisdictions because there is not an equal transposition of the directive by each country. Some have still not completed their implementation.
Paul Stillabower, RBC: And the directive is not really finalised yet. There’s a big outstanding issue to do with delegation of responsibilities, in particular assets held by the prime broker, as delegation agent to the depositary, and how those assets are to be segregated. This could have quite a large impact. The prime brokers will presumably see more cost and/or less revenue if they have a further level of segregation and that will flow into the pricing.
There was a rush to get the directive implemented in time and the industry did well to get our clients over the line in the countries that have transposed the directive. But now it has to be transposed in all the countries and the reporting has to be nailed down where it is not working as planned, such as in the UK.
Brian McMahon, BNY Mellon: It was a very large-scale directive and we got over the line, but there are still a lot of core principles that need to be addressed, like the reporting. And given a lot of firms left it very late in respect of compliance, and with Ucits V coming this year, it is important that clients consider their implementation plans as soon as possible.
Yvan de Laurentis, BNP Paribas: Some asset managers may have been late in their implementation but the depositories have been looking at the issues since the beginning and they are ready.
Gaëlle Kerboeuf, Caceis: From the depositary and custodian perspective, all the paperwork has been completed concerning clients. The contracts have been updated to take into account all the new restrictions and enhanced depositary liabilities. One potential difficulty I can point out notably is the new cash monitoring role for depositories, because it overlaps with the role of other players – the administrators, the auditors and even the managers – and an unintended consequence of the AIFMD may be that the managers feel they have less responsibility and may act less rigorously in their own due diligence and transparency duties.
Paul Faltz, Citi: The AIFMD is probably one of the biggest pieces of legislation that I have seen in my career. If you would have asked me two years ago whether we would stand where we are today, I would have subscribed with two hands. We are in a situation where we have regulated an industry that was utterly unregulated. We now have European Union (EU)-based alternative investment managers that have a passport and can sell their services and distribute products into Europe. So there has been a lot of progress, but there have also been teething problems with the implementation.
With regard to depositary banks, Citi was ready in time and could fully leverage its extended proprietary sub-custody and network management and existing investment restriction capabilities. The biggest challenges have been the discharging of responsibilities to the prime broker, as well as dealing with the volume of cash monitoring.
Isabelle Goethals, HSBC: The appointment of delegates and evidencing the level of segregation went smoothly for the sub-custody network. The biggest issue was with the prime broker because they didn’t get involved at an early enough stage. The depositary rights to access prime brokers’ premises and records at any time took longer to negotiate than initially expected.
Stillabower: I think that perhaps the prime brokers ultimately played a winning hand by not playing at all. But the real issue is that one cannot yet come to any conclusion on what the final model looks like. There are three outstanding issues. Firstly, what happens outside of Europe in terms of an insolvency, because another jurisdiction (like the US) may not recognise the concept of segregation of assets nor the depositary’s authority over the same. Secondly, what is happening to the smaller clients? There is a heavy regulatory burden on depositaries and prime brokers and alternative investment funds and that is making the economics of servicing smaller clients less attractive. The last issue is on bundling. A bundled proposition may well be the only way to provide clients with a service at a reasonable cost in the future.
Kerboeuf: It is a new role for the depositaries because our clients are looking to us to help them with the new day-to-day tasks they have, such as reporting, passporting and distribution, which is good news for us because it means our role moves more and more from a traditional depositary bank to a full asset-servicing provider with lots of new additional services.
McMahon: There was a depositary framework in Luxembourg before the introduction of AIFMD but what the directive has done is formalise the depositary role across Europe and help to educate our clients about the function.
Goethals: The education was key. Many of the large asset managers were prepared, but smaller ones did not understand the scale of the new depositary services or how the service was different. Some assumed that all duties were already performed within the scope of pre-AIFMD services. We spent a significant amount of time providing regulatory support and guidance to our clients, to help them understand the real added value of the services in terms of investor protection and the role that the alternative investment fund managers had to play for successful and timely implementation of the directive.
De Laurentis: There has been an expertise gap to fill. The depositaries have been working on this for some time but many of the alternative investment fund managers were not as prepared, so there have been complex discussions about operating models and oversight. Now, with Ucits V coming up, this should be less of a challenge, because we have gone through much of it already and the role of the depositary has become clearer. In many countries, like France, Germany and Italy, there was already strong regulation of either oversight or restitution duty. In Luxembourg, it was more principles-based, but now we have specific deliverables, so that is a new challenge. Our duty as depositary will increase. We will have to be more present in the governance of the client and on ongoing controls and we have to challenge the client’s operations more regularly.
McMahon: The passporting of the alternative fund managers has worked phenomenally well. The German side is more challenging, given the manner in which AIFMD has been introduced and the delegation component, but managers in other markets – France, the UK or Luxembourg – have all embraced it. So I think it will increase asset allocation and be a positive development for the industry.
Faltz: A crucial question at the outset of the AIFMD initiative was what non-EU managers would do. We have seen managers abandoning EU fund distribution because the critical mass was not there. I am convinced that once the codes are there, once non-EU managers better understand how AIFMD will work, and we have established service providers, third-party management companies and a stabilised infrastructure, that the non-EU managers will come back and will use the alternative investment fund manager as a depositary.
Gomez: This is why, probably by July this year, we will know what will happen with non-European fund managers and offshore funds, if they are to comply with the full depositary function or not.
Stillabower: Ultimately, if you’re selling an alternative investment fund into Europe, you’re going to be captured by AIFMD. So, although there was a race from several managers to use a depo-lite model, it’s likely to last for a certain time only, and at some point those funds will be captured by the AIFMD and subject to appointing a full depositary.
Faltz: Service providers were also developing solutions to help asset managers to comply with their regulatory reporting obligations. We all struggled to get it over the line in time. Given the time pressure, we all implemented individual reporting solutions, which are not cost-efficient for the industry.
The large panoply of solutions offered by a multitude of service providers provides a lot of choice and flexibility to managers, ranging from all inhouse to full outsourcing. Some clients have inevitably picked a combination of unbundled services from specialist providers, creating voluminous input data transfers across our organisations, preliminary to the final report compilation.
Over the next few years, the industry needs to find a way to industrialise these processes and a standard way to exchange the input data. This is not about competitive advantage, this is about creating cost-efficient standards, allowing our organisations to exchange data. The same standards are required for Solvency II, Packaged Retail Investment Products, and the European Market Infrastructure Regulation. The fund industry should look at defining these common standards to reduce cost.
Gomez: The difficulty is that the reporting has not been set up for alternative investment funds; it has been set up for hedge fund business. If you look at reporting data, 80% of it does not apply to private equity business or real estate business. For example, you do not have information like Value at Risk, or document indicators like, for example, in those industries. The AIFMD has been primarily designed for the hedge fund business and this is why we have a big issue with data reporting.
Goethals: We should also be looking at due diligence standards. Obviously, it is up to each provider to decide on the extent of the on-site due diligence but in terms of questionnaires, there are so many different formats. All players perform due diligence on each other, so as an industry, we should be looking at setting benchmarks and standardising the format of the questionnaires.
Kerboeuf: That will certainly be a new target for the European Securities and Markets Authority (Esma), whose role is to try and harmonise the standards between all member states. It seems indeed necessary to have different data reporting depending on the type of fund, but identical for the same type of funds domiciled in different member states.
Faltz: From a Luxembourg industry perspective, the implementation was well co-ordinated. The legislator traditionally stuck to the EU directive text, the Commission de Surveillance du Secteur Financier (CSSF) was pragmatic and supportive by imposing reasonable deadlines and issuing frequent FAQ updates, and the Association of the Luxembourg Fund Industry (Alfi) played a crucial role in the co-ordination through active working groups and FAQ guidance.
Funds Europe: How exactly have the prime brokers played a ‘winning hand’ as regards AIFMD?
Gomez: We complain about the prime brokers, but they have another interpretation of the directive and segregation of assets. The question for them is whether segregation creates any added value for the investor, or does it create more risk and more cost. Esma needs to clarify this, but so far we have no clarification. Most of the large depositary banks have set up what we call an indemnity letter, or discharge of liability, to protect themselves against a prime broker not using segregation, but a judge might not accept them.
De Laurentis: Indeed, the discharge might be put aside for legal reasons, because it needs an ‘objective reason’ to be valid, plus it can be discarded by regulators or the courts. The indemnity, the bilateral agreement that one entity has with another, cannot be discarded as long as the other entity is still bound by the agreement.
Stillabower: True, but the main question is about what happens if a prime broker fails. The indemnity when a prime broker fails is not very robust. For the prime brokers, their starting point and their ending point of negotiation was exactly the same: ‘We want it to look exactly the way it looks today, and there’s no reason why it should change.’ And there was just not enough time to reach a suitable compromise.
Kerboeuf: The prime brokers’ business model does not allow segregation. It is based on bringing together all the assets and reusing them. So whether a prime broker should be able to do what a depositary is prohibited from doing is an economic and a philosophical discussion. Do we want to completely eradicate the prime broker business or not? This question is not tackled by the directive. As a depositary, we have to try hard to ensure that prime brokers are part of the network and that we can work together closely on due diligence.
Funds Europe: Has it been possible to judge the impact of regulation for end investors? Has it made the market a safer place but also a more costly one in which to do business?
McMahon: In the hedge fund market, the cost of entry has increased substantially because of regulation and that is changing the dynamics of the industry and giving investors fewer products to choose from.
De Laurentis: It is always worth asking how much is generated by regulation in terms of the return on investment versus the cost that it brings to the various service providers and investors. We are always eager for the likes of Esma or the European Commission to assess the impact and ensure these regulatory changes have generated added value for investors, which we’re confident they have. The AIFMD was triggered by disruptions during the financial crisis and the expectation was that there would be a strong response to regulate the hedge fund market.
Gomez: It was also designed to protect the European market. If you want to do business in Europe, you have to set up in Luxembourg or an equivalent EU domicile. We will see in 2018 what happens for non-European managers in terms of private placement versus reverse solicitation. Today it is a big question mark as well as the future of depo-lites, where you act as a depositary but without the liability. And what will it mean for European managers with offshore funds that want to sell to European investors? Will they be allowed to carry on doing that, or will they have to comply fully with the directive?
Kerboeuf: Hopefully that is what will happen, but while people outside Europe will be able to sell their products into Europe if they have a passport or meet the various conditions, the contrary is not true. Nothing has been done about reciprocity – I have specially in mind the United States, which is imposing on its side stringent conditions for European funds to be distributed in their territories.
McMahon: For that reason, I don’t believe it’s a protectionist form of regulation. It has investor protection at its core. The question is whether it is the most efficient way to protect investors. For example, a private equity investment may go bust just because the business underpinning it has failed. The directive’s extra level of oversight won’t prevent that, nor should it. And therein lies the conundrum. For example, the directive calls for independent valuations, but the private equity firm may well consider itself to be best placed to value that business – it bought the business, it knows the plans for it and how the team is working. How is an independent party going to be able to do that?
Faltz: The sheer mass of regulations have profoundly changed the industry. The changes are costly, hence there is a need for continuous automation. It is undeniable that the changes have led to better management practice, clearer responsibilities, stronger product governance, improved transparency and risk protection. That should lead to a better product. So the question is whether this warrants the cost. An example would be valuation. The directive enshrines best practice into law across the alternative investment world, such as independent valuations from the portfolio management
Stillabower: But ultimately, it will be a cost question. Prior to implementation, the whole industry, not just depositaries, spent their time getting clients and processes over the line and educating clients. But the industry was still working through exactly what it means to operate under the AIFMD. For depositaries, for example, to have liability for an independent administrator or a prime broker, what our own depositary functions had to do and what satisfies the regulation. We needed to understand the actual cost of delivering that service, and the risk involved in delivering the service.
Goethals: But while we are bedding down our operations, we are also looking at the potential for efficiencies – central utility centres, potentially – and that’s something we didn’t have the chance to do because the focus was on implementation.
Kerboeuf: Efficiency will be gained in the second phase because first the depositaries banks have to implement all the new systems and processes. We indeed have to pay a consultancy cost for ensuring we have the best IT systems in place, we have to educate people, we have to implement operationally all the new rules and procedures, so it does obviously trigger cost rises. However, following the industry trend, we have not passed those costs on to our clients, which may be surprising.
On the other hand, we have developed many additional services which bring in additional revenue, like reporting services, but which require a lot of additional work to develop expertise and launch new systems. So I think it’s a complicated issue for the market.
Gomez: It’s complicated for our business. The alternative investment funds include private equity and real estate and it will be very difficult to automate processes and have IT systems for both of these sectors. One size will not fit all. This is why we see a great increase of assets for Ucits, but less for alternative investment funds, because depositary banks want to enter this market. I’m not sure whether you will see the market have a specification between the large custodians or the depositaries. It is like deciding whether to go to a supermarket or a specialist supplier for certain groceries. It’s a big question of cost and transparency.
De Laurentis: All service providers have had to deal with an increase in manufacturing costs. We have been able to absorb these because the implementation was so rapid, but in the future, and with new clients coming in, we may see instances where the cost could be included in the pricing.
McMahon: But there are new clients in the market today and the price is still very lean.
Stillabower: I just think the pricing model is still working its way through the system.
Kerboeuf: We tackled this issue by having dedicated teams for dedicated products.
As an example, we have created a dedicated business line called Peres (Private Equity, Real Estate and Securitisation Global Services). Not only sales forces are in contact with the asset managers of that segment, but the whole operational chain is also different from the other business lines, such as traditional funds or hedge funds. The way we service the client is different depending on the business line addressing thus their specific operational and business needs. Although we are a global asset servicer, we try indeed to have a service dedicated to each business segment and each project.
McMahon: It’s a really important point. Are you going to go to a mainstream provider or are you going to go to a small boutique? It’s one of the big conversations around this whole space. I personally believe there is space for both.
Faltz: Cost is going to bring out the discussion on critical mass. Firstly, I don’t think the regulation necessarily increases cost in the long term, but it does raise the minimum amount of assets needed to do business at a reasonable cost. This will force some consolidation and re-absorb the cost issue at least partially.
Secondly, regulation can sometimes reduce cost. For example, the discussion on inducement fees or an initiative like Target2Securities forces the market to reduce cost. Ultimately, cost forces all of us to keep very tight operating models and to make disciplined decisions on our service offering.
Funds Europe: What are likely to be the priorities for asset managers and their clients over the next 12 months?
Stillabower: Ucits V is a huge initiative and we want to use the experience of the AIFMD. We are expecting another bottleneck due to the likely repapering of prospectus requirements and sub-custody arrangements, but there will also be some different challenges.
And then we will also have to tie it all together with other regulations around investor protection, like Dodd Frank, the Markets in Financial Instruments Directive (MiFID) II and Solvency II.
De Laurentis: In addition to regulation, there are also performance challenges and the type of investments that asset managers are looking at. With interest rates remaining low, investors are asking more questions about managing their cash, so we could see more products around the cash management of long balances within the funds or cash collateral reinvestments techniques. That has operational implications, so as a depositary we will look to support them in terms of the legal agreements and the risk management.
The other big trend is the investment in so-called China A shares. Previous schemes, like the Qualified Foreign Institutional Investor (QFII) programme and the Renminbi Qualified Foreign Institutional Investor (RQFII) programme, were linked to licences and quotas and were less accessible, but new programmes like Shanghai-Hong Kong Stock Connect have made that market more accessible in terms of custody arrangements, and that has made it easier to help clients who are looking to invest directly in Chinese assets.
Faltz: With the low interest rates and returns, there is going to be a shift to alternative investment strategies from both institutional and retail investors.
A CitiVelocity research paper forecasts a €300 billion inflow into complex Ucits over the next five years. That might blur the boundaries between alternative and true Ucits products.
The loans market will also explode, as many banks will offload their loan portfolios. The EU Commission or [its president Jean-Claude] Juncker’s plans for public-private partnership in financing the infrastructure need to go in the same direction.
That is something we have to prepare for. How do you create an operating platform that can deal with all the hybrid products that contain not just loans but real estate, private equity and long investments, all in one vehicle?
Traditionally, we had separate platforms for long-only funds and for alternatives.
Now we have to rethink that and move to a model where we service bespoke asset classes with a general net asset value control overlay, rather than maintain general functional activities such as processing, reconciliation and pricing.
McMahon: Substantially more funds are impacted by Ucits V than AIFMD, so I anticipate a heavy workload with Ucits V filings. And we are seeing more asset managers moving jurisdiction and diversifying their asset allocation.
The deleveraging of the banks and the low interest rates are changing the dynamics in the investment market and the institutional allocation of cash to alternatives is increasing exponentially.
Gomez: We have the feeling, from talking to the European Commission, that there will be no new regulation for the time being. I think asset managers and service providers will focus on consolidation, standardisation of processes and how to provide more information, to protect investors without increasing cost.
Goethals: Ucits V is definitely our priority this year as Ucits is our core business. But I think we shouldn’t underestimate the impact of MiFID II. It has a huge impact on managers’ distribution model and remuneration and there will be a knock-on effect for service providers. So we have to bring more efficiency to our current operating model to limit the cost of new regulation and the ultimate impact on investors’ revenues.
Kerboeuf: Over the next 12 months we will be focused on Ucits V, but also Ucits VI. The idea of a depositary passport may change the way we work within Europe, especially in terms of contracts. As managers develop, distribute and manage their products all over Europe, they will want a depositary that can do the same. So we have to be ready to offer a globally harmonised set of services.
The main new areas of development for Caceis are to offer bridge financing to private equity investors as well as derivatives-clearing activities (both for listed and over-the-counter) under Emir.
Finally, we are expanding our presence in more European centres and have applied for depositary and banking licences in the UK and in Switzerland, to broaden our coverage of markets and local presence, notably in the UK and in Asia.
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