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INSIDE VIEW: The end of the affair?

Breaking heartTraditional relationships between fund managers and their custodians and prime brokers need to be redefined. Andrew Dollery of Newedge says things became murky with the AIFMD.

The countdown for firms to become compliant with the new Alternative Investment Fund Managers Directive (AIFMD), which has been four years in the making, is characterised by uncertainty and confusion.

What effect will the new rules regarding depositary liability have on the way fund managers deal with their prime brokers and custodians? With traditional lines of engagement being blurred, how will these relationships now work?

Consensus does exist that regulation will prompt a reappraisal of risk pricing which will lead to some fund managers having to pay more for custodial and prime brokerage services. Where things get murky, however, is the oversight of assets and liability management.

The AIFMD seeks to secure an additional layer of protection for investors. But this layering process involves custodians potentially taking on unprecedented levels of liability – something with which they are not wholly comfortable.  

The knock-on effect for customers is that custodians and prime brokers may refuse to take on management of non-vanilla assets. Alternatively, fund managers will simply be charged more than in the past to take on additional liability and the associated risk.

Additionally, the directive may also affect the availability of assets for rehypothecation, namely where assets are transferred by fund managers and reused by prime brokers as collateral to support their clients' trading activities.  Rehypothecation provides valuable funding efficiencies for prime brokers that ultimately lower costs for end asset owners.

While there are technically no restrictions that stop prime brokers rehypothecating assets, the additional liability that AIFMD confers on the depositary means that this will become a more contentious issue than before.

To what extent which prime brokers will hold unencumbered assets in custody, and whether assets that are not rehypothecated can, or should, be sent back to the custodian remain questions yet to be answered.

Such confusion means that situations are likely where the custody of an asset is passed backwards and forwards multiple times between a fund manager’s prime broker and custodian, adding operational cost and complexity.

Uncertainty has resulted in a range of responses, as member countries choose to interpret the impending rules differently.  

For example, the Central Bank of Ireland recently released comments that suggest it may consider allowing a liability discharge model – where depositary liability is shifted from the custodian to the prime broker.

In other jurisdictions, such as Germany, it seems likely that a stricter interpretation of the AIFMD will be used.

Of course, adhering to these “rules within rules” will come at a cost – a cost which all participants in the custody chain are likely to bear in one form or another.

Custodian banks that take on additional liability are likely to raise fees to compensate. The costs for prime brokers may rise because of the necessity of segmenting the assets between custodian and prime broker, and potentially within their own books, between alternative investment funds and non-alternative investment funds, as classified under the directive.

Beyond additional cost pressures, prime brokers and custodians will also have to deal with the fact that the new rules for depository liability concentrate on physical securities only – such as the fundamental hedge fund strategies.

There is little consideration of derivative-based strategies under the AIFMD, so commodity trading advisors or fund managers pursuing macro strategies may be left confused as to how their custody relationships must change in order to comply. Although, ultimately, they will be less affected by the depositary rules.

Of course, to begin with, the EU Commission has insisted on investment fund managers complying on a “best efforts” basis.  

Legally, in many jurisdictions as a result of the transitional arrangements, managers will have up to 12 months to seek the necessary permissions to obtain authorisation. As such, there is still time for the industry to untangle the web of complexity and confusion that the directive has created.

While solving the AIFMD conundrum will be tough, it is not insurmountable. It is time to redefine the traditional relationship between fund managers and their custodians and prime brokers in order to realise the new landscape’s opportunities.

We need to become more closely acquainted.

Andrew Dollery is a director of origination and structuring at Newedg

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