Editor’s note: The following material is provided by Advent Software from a recent Roundtable event it hosted in London. The participants were Joan Kehoe, founder and chief executive of Quintillion; Tom Kirkpatrick, MD, Enterprise Risk Management, GlobeOp; Rhodri Mason, head of UCITS Management, Man Investments; Bill Scrimgeour, global head of regulatory and industry affairs, Institutional Fund Services at HSBC; Natalie Westbarkey, VP Securities and Fund Services, Capital Markets and Banking at Citi. The event was moderated by Thomas Zdon, Advent Software.

This publication is grateful to Advent for being able to publish this material. To view a related White Paper on the Alternative Investment Fund Managers Directive, click here.

One of the key features of the EU’s Alternative Investment Fund Managers Directive is the requirement to appoint depositories for all managers. However, early drafts suggested such depositories might face unlimited liability for the loss of AIFM assets. This issue has since been (partially) addressed but members of Advent Software’s June roundtable on the AIFMD expressed considerable doubts about the potential effectiveness of depositories and how desirable/straightforward it will be to take on that role.

Regulations and Cost

Scrimgeour: Investor protection comes at a cost. We’ve always assumed in the institutional, hedge fund and private equity worlds that the investors are sophisticated, largely institutional and have their own due diligence processes ... and that has worked up to a point. Meeting these regulations will bring an additional cost, having a depository will bring an additional cost because it is a new entity in an already fragmented value chain.

Westerbarkey: I think that is one of the major changes with the AIFMD, the fact that all of the alternative or “non-UCITS” managers will have to appoint depositories in the future which is not the case right now. This is one example of increased regulation and particularly when it comes to stricter liability for depositories, which could be considered as over regulation.

Becoming a Depository

Westerbarkey: The next phase of the AIFMD is now the Level 2 Legislation to be designed over this coming year. From a depository perspective the two key things are 1) the definition of a loss of financial asset, i.e. what constitutes a “loss”; and 2) exactly what is meant or covered by “liability”. So the devil here lies in the detail.

Scrimgeour: The Level 2 detail will put some more comfort levels around what it means to the industry as a whole. It will codify certain additional things, which can only be a good thing, but it does mean increased levels of liability for some. Therefore there needs to be a rebalancing of the risk/reward relationship, particular if the depositories are going to be asked to take on greater levels of liability, otherwise it just doesn’t make it commercially viable and nobody will become a depository. It’s as simple as that.

Westerbarkey: In more risky, emerging markets it may become more difficult for alternative asset managers to invest in as they will have to appoint a depository, which in some countries may not match the new regulatory criteria. Ultimately, this may limit geographically the investment opportunities of the manager. As non-UCITS asset managers in future will need to appoint a depository it does, however, open further opportunities for depositories. Particular those service providers that are already well-established and that have a large network of local market presence are likely to benefit from new business. In addition those providers that offer not just depository, but various other services across the value chain such as fiduciary and prime brokerage services will be uniquely positioned as they will be able to mitigate any risks across the wider firm. So the bigger players are at a natural advantage, but will need to ensure functional segregation.

Depository Responsibilities

Scrimgeour: This [the depository] is a brand new appointment which apart from anything else will mean that all legal contracts are going to be rescinded and new contractual relationships agreed.  … This new entity that will now have to be fitted into the hedge fund world, will have three principal obligations: 1) an oversight responsibility, or in other words to make sure that things are being done according to the mandates, 2) a liability to replace any assets if they’re lost and 3) to verify assets and make sure on an ongoing basis that they are verified but if they are appointing any underlying custodians they’ll also have to do due diligence on those custodians, which we do anyway.…The main thing to consider is most hedge fund managers will use a prime broker and that we’re not quite sure just what sort of responsibility the depository will take for the prime brokers.

Kehoe: The degree of oversight currently implied in the description of the depository function is extremely demanding. As an administrator, there is an obvious opportunity to help in this process as the administrator is one place where all data relating to funds must be housed.

Kirkpatrick: You’re talking about a more complex product set, diverse locations and ways of recording assets as well. So then it becomes: “What is the extent of those oversight responsibilities and how does the depository discharge those responsibilities?” Is it simply obtaining and reviewing reconciliations from the administrator or is it going deeper?…The ability to present that data quickly, accurately and verified in a number of formats will be critical in helping both the depositories and investors to meet their objectives. We’re seeing a move towards greater liquidity frequency in the hedge fund world now.  Weekly NAVs are often required and so it’s important to establish sound controls to ensure accuracy in a much tighter timeframe. Therefore technology flexibility is absolutely critical to be able to meet the requirements of the market.

Size Matters

Kehoe: I’ve heard some of the big guys say, “There is no place for small independents in this new world”. I clearly have a different perspective on that …which is that I believe that some of the newer players actually have technology in place that facilitates transparency more readily than many of our larger competitors. It’s a bit like the Cayman argument. Is Cayman dead as many people predicted with the original AIFMD draft?  No it’s not. Are independent administrators going to die? No they’re not. In fact many of them may thrive in this new world.

Westerbarkey: There is an opportunity for both larger and smaller players. I think the opportunity for smaller players is greater in terms of innovation as they are often quicker and nimbler in developing and applying new technologies. For larger players the opportunity rather lies on the scalability side, because they typically have that necessary global reach which allows them to deploy their technology at global level. Large institutions may, however find it harder to be innovative at technological level because they are usually busy reconciling, integrating or retiring legacy systems.

Zdon: We’re seeing actually from a technology spin where we’re getting the most attraction is people are pressing us for more independent valuations of derivatives and sources of that information. The fund administration space which was traditional T + 3, T + 5, T + 7 is now moving into a T + 0 environment. The pressure is on in appliance tools and risk tools to meet the requirements both of the UCITS and AIFMD. … We find distinct differences in the start up through emerging to maturing and franchise firms. At the upper level - many firms grew adding systems around a basic core – what was previously doable with human capital is starting to lose its ability to scale when complexity goes up and timeliness requirements speed up.

Concentration – Another Lehman?

Scrimgeour: Under the AIFMD, the prime broker can act as a depository but I suspect many will not wish to undertake this activity and therefore there is a question of who has liability for the unencumbered assets in safe custody?

Westerbarkey: I think the new regulation with strict liability will definitely raise the entry barriers for any new player that wants to enter the custody space. It seems therefore questionable whether prime brokers would look to become depositories and they would also need to put into place a clear functional segregation according to the new law. Generally I’d be surprised to see more players entering the depository business. Instead, it seems more likely the smaller players would potentially re-think their position or even consider exiting the depository space given the high risks associated with the business in future. Overall this could create greater consolidation leading to an increased concentration of risk in the custody industry which is a potential effect that I understand regulators are aware of although it is not their intention to cause such outcome. 

Zdon. Well that was one of the questions: with the legislation to reduce risk, would the concentration of asses with depositories achieve that goal, does that not increase counterparty risk? Are we increasing the chance of another Lehman?

All: Yes exactly.

Westerbarkey: Concentration of the industry is not the desired but the potential outcome.