The role of the depositary is set to become an integral part of how offshore hedge funds operate in Europe under the AIFM Directive, which will be transposed into law on 22 July 2013. Never before have Cayman-based hedge fund managers had to think about using depositaries.
Under the Directive, though, the depositary’s role with any given AIF will be much higher profile. It will be held liable for the loss of any financial instruments held with third-party sub-custody accounts.
What this means is that the depositary will become more important in the terms of the AIF manager’s decision making process. It will want to know exactly which prime brokers are being used, what markets they are trading in, because they will be on the hook for anything that goes awry. From 22 July, for any funds in scope of the Depositary provisions of AIFMD, they will be responsible for three key functions:
• Safe keeping of assets;
• Monitor cash movements between the AIF and its counterparties;
• Provide general oversight of the fund’s investment activities.
“The depositary will also be more involved in the content of the prospectus, particularly around markets in which the fund trades in, the risk profile that it is prepared to take on, and ultimately, the risk profile that the depositary underwrites. If a manager has a great idea for a trading strategy, while the depositary is unlikely to say ‘No’, it will nevertheless have a view and it will price the risk of the market(s) the manager wants to trade in, and the prime brokers it wants to use, accordingly,” explains Mike Hughes (pictured), Global Head of Fund Services at Deutsche Bank.
In preparation for this major market re-structure, Deutsche Bank has developed an AIFMD-compliant ‘one bank’ solution, which offers managers the opportunity to leverage from a fully integrated model that ensures they remain fully compliant with the Directive at minimal cost and disruption.
Ultimately, the depositary will become responsible for duplicating multiple tasks that a manager’s existing service providers already address i.e. asset verification and cash monitoring typically performed by the fund administrator using data flows from the prime broker. But if one considers the cash monitoring role in the context of fund oversight, it extends even further:
“What cash is with the primes? What cash is with OTC counterparties? What cash is invested in money market funds? Where is cash moving? If the prime broker’s cash accounts are with Deutsche Bank, for instance, and then all of a sudden on Monday morning that cash goes through accounts of a different bank, why?
“That example is already a case management issue for a depositary; it could be a completely legitimate reason, but that is the oversight role that a depositary will be expected to provide. It’s all-encompassing: the depositary has to know where the cash is on a T+1 basis and flag issues to investors as and when they arise,” explains Hughes.
One of the key drawbacks to not using an integrated approach is that appointing a separate independent depositary will cost the manager and impact the fund’s TER. The depositary effectively ends up duplicating what the manager’s existing service providers are already doing. An integrated model leverages the existing services already being provided and, as there are fewer external counterparties, there is a lower risk premium applied.
Before explaining the key features of an integrated model, it is worth noting that there are, in fact, three types of depositary models for managers to consider.
First, the integrated model itself, which should mean minimal impact to a fund’s TER because it limits the number of external service providers the depositary needs to engage. Second, is what Hughes refers to as the “risk premium” model wherein a manager uses multiple prime brokers, but with a common depositary and administrator. A risk premium is charged by the depositary because it has to assume the risk of the additional prime broker(s). Third, which carries the highest risk premium, is the model in which a depositary is appointed on a standalone basis and wherein the manager continues to use an independent administrator, multiple primes, agent banks etc.
“In that third model, we have to take in multiple feeds, reconcile them, and basically perform a shadow NAV by rebuilding the portfolio. This model has the highest risk premium because you’re pricing risk on the prime brokers as well as other service providers,” comments Hughes.
This model, where the depositary function is split from administration and prime brokerage services, will be the most expensive option for managers. For some, whose funds are delivering strong performance, the impact on TER might be manageable, but for the majority of managers keen to protect their margins as much as possible, the lower the costs involved the better.
The case for an integrated model
In Deutsche Bank’s view, there is a compelling argument for the integrated model in which depositary services, administration, cash management, corporate administration, sub custody and serving as one of the fund’s prime brokers, are all performed within the same organisation. Instantly, this reduces depositary risk and avoids the cost of duplication.
“Everything that the hedge fund is doing has to be captured on a daily basis, and managed. The more of the value chain that we can capture, the least number of external reconciliation and data breakpoints we will have to deal with,” says Hughes. This will be possible by ensuring that the depositary function within the bank is legally and hierarchically separated within Deutsche Bank (something that all banking organisations who pursue this model will need to ensure).
“As we are capturing data through the bank’s internal systems, reconciling it, and bringing it in to our own general ledger, the less impact it will have on the manager. Rather than building extensive external data feeds, we can rely on those already in place. We have built a depositary oversight model to reconcile all of the feeds from the bank’s existing infrastructure.”
Risk is therefore contained within the four walls of Deutsche Bank. And that means minimal cost to the manager because the risk premium is reduced.
That’s not to say that all clients will revert back to the old days of using a sole prime broker. Hughes sees no evidence of that occurring, but some managers who are, perhaps, using 10 prime brokers might well decide to pare that back to four or five under the Directive; not least because the depositary will unlikely support such a business model because of the diversification and complexity of the risk this creates.
“If you are using three primes, each supporting say 33 per cent of your book, one of which is Deutsche Bank, the other two primes will come with a risk premium. Exactly how much that premium will be will depend on how you are trading with them, and in what markets,” clarifies Hughes.
For example, if a manager is trading frontier markets, a higher risk premium will be attached to that than for trading established markets.
“That’s why the depositary needs to be brought into the loop early on to understand how and with whom the manager is trading. Even if the client is using a completely integrated solution with Deutsche Bank, and wants to trade solely in frontier markets, we might have a problem with that because we might not be the sub-custodian in those markets.”
With the AIFM Directive just days away, there is no excuse for depositaries to be unprepared. The time for posturing is over.
“We have to deliver a solution now that protects investors. We believe that delivering that solution in an integrated model makes it much more cost-effective for a manager than in a non-integrated model,” concludes Hughes. “AIFMD is here. Deutsche Bank is ready.”
