Ucits V could turn depositories into insurers

Safety boxDepository banks could be forced to 'insure' assets held in Ucits funds against risks beyond their control, putting up costs for investors as a result, a major fund body warned today.

The proposed Ucits V regulations could make depositories liable for losses in all circumstances, including insolvency, said the Association of the Luxembourg Funds Industry (Alfi). The depository function is usually provided by custody banks that keep fund assets in safe-keeping.

The proposals realise what had always been expected: that the stricter liability regime for depositories contained in the Alternative Investment Fund Managers (Aifm) directive would soak through to the Ucits world. It was always deemed unpalatable that funds aimed at sophisticated investors under Aifm would have greater safeguards than Ucits-regulated funds, which are aimed mainly at the wider public.

Responding to the proposals that were published on 3 July, Alfi praised the proposal for providing clarity on the rules for depository negligence.

If a Ucits fund suffers losses due to a depository's negligence, or if financial instruments held in custody are lost, the depository must meet the cost, says the proposal. The rule applies even when losses are due to a sub-custodian.

The burden of proof will lie with the depository, which must demonstrate it performed its duties correctly in cases of lost assets.

But Alfi also said the proposal left questions about what other liabilities depositories would have.

“Should depositories cover all categories of risk, including insolvency and fraud?” questioned the statement. “Alfi believes that if depositories are held liable for investment losses in all circumstances, they become ‘insurers’ for risks beyond their control.”

The cost to depositories for providing nearly absolute protection would be high, said Alfi, and would most likely be passed on to the end investor. Such a system may even encourage inefficient use of capital by making investors believe their investments are risk-free.

If depositories are obliged to provide coverage for the risks run by all members of the Ucits chain, this may also pose a systemic problem by concentrating risk among a small group of depositories, the group added.

Alfi said it hoped the final draft of the proposal will strike a balance between investor protection and the need to minimise cost to the end investor.

Once the Ucits V directive is passed it must be transposed into law by the European Union member states. At the end of the first quarter, accounting firm KPMG produced a report showing that 13 member states had still not fully implemented the Ucits IV directive, despite a deadline of 1 July 2011.

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