Understanding the role of the depository under AIFMD
The Alternative Investment Fund Managers Directive (AIFMD) has many moving parts for alternative investment fund managers to get their heads around. But perhaps one of the most salient issues they face – particularly managers running offshore funds – is the requirement to appoint a depository.
The vast majority of hedge fund managers have never had to do this before and whilst much of the dust has settled in terms of cost impact, there are still a lot of operational and practical details that managers are looking to get answers for.
At the heart of this is determining the type of depository models available.
To briefly summarise, any AIFM running an EU-based AIF will require a full depository solution under AIFMD to carry out three core duties under Article 21 of the directive: namely cash management, safekeeping of assets and general oversight of the AIF.
Such a depository agreement will need to be in place by this summer. For AIFMs running non-EU funds (i.e. Caribbean-based hedge funds) they can appoint one or more entities to carry out these same duties in what is referred to as a ‘depo lite’ solution whereby the appointed offshore depository does not have near strict liability for the loss of any assets in the AIF.
This has the benefit to managers in that they will be able to maintain their existing counterparty relationships with their prime broker(s) and administrator. Under full AIFMD, depositories will vary on the extent to which managers can maintain these counterparty relationships as they will need to assess the risks involved in meeting near strict liability.
“After 2015 ESMA will opine on whether it will insist on a single depository being used, inclusive of the near strict liability for the loss of financial assets in custody, which applies at present only to EU domiciled AIFMD-compliant funds.
“We also anticipate ESMA will determine where the location of the depository will have to be: either where the AIFM is located or where the fund is located,” comments David O’Keeffe, CEO at SMT Trustees (Ireland) Limited, part of SuMi TRUST Global Asset Services, who continues:
“In the offshore world, if we are only providing the independent oversight function it doesn’t matter as much how many prime brokers are involved because we are not exposed to the same level of risk and more specifically in respect to the near strict liability for the loss of financial assets. Where other existing service providers may absorb any incremental costs to undertake some of the duties of a depository often the only extra cost to the manager using a ‘depo lite solution’ is the oversight function that an independent depository may be appointed to undertake.”
“We offer both onshore and offshore depository services for alternative fund managers. We can support both the integrated and open architecture models under the full AIFMD requirements as well as the depo lite model for offshore funds,” adds Gavin Byrnes, Head of Business Development, UBS Fund Services in London.
Integration versus open architecture under AIFMD
AIFMs will have two models to choose from: either a fully integrated model where the appointed depository acts as the sole counterparty (providing prime brokerage, fund administration and custodian services) or a de-coupled model which will allow them to maintain existing prime brokerage relationships.
Deutsche Bank will support both models. After all, it isn’t feasible for larger managers to move lock, stock and barrel into a single counterparty relationship under AIFMD – one could argue that the concentration risk that would create would be counter intuitive to the directive’s aim of better protecting investors.
However, there are many benefits to the integrated model and it is something that Deutsche Bank, and others, are keen to provide.
“Our model is very much the integrated approach where we can provide all the post trade services a manager might need under AIFMD and has thus far been well received by fund managers. Certainly for new managers, being able to choose an integrated model is an attractive proposition. For larger managers with well developed infrastructures in place, the menu model where managers can pick and choose services also works very well,” explains Mike Hughes, Global Head of Fund Services at Deutsche Bank.
This de-coupled model is where a firm like Deutsche Bank provides everything from prime brokerage, fund administration, depository, cash management, investor reporting and investor services: managers can pick and choose which services they require, which under depo lite, for example, might be for Deutsche Bank to be appointed purely to provide the oversight function.
One of the major benefits to managers who use the integrated model is cost. As mentioned earlier, the onshore depository will be on the hook for any liabilities suffered in the AIF as a result of asset misappropriation. This means that the depository will have to conduct a robust risk assessment of the AIF if the AIFM chooses to continue using multiple prime brokers and the cost impact to the manager will be higher.
“The most important thing for a depository to consider is the counterparties attached to the AIF,” explains Hughes.
“With the integrated model, a lot of the risk can be internalised and the cost impact to the manager is reduced. Where external prime brokers are being used we need to determine: who is the counterparty? Which legal entity is involved? What markets are they trading? What is the registration process in the underlying market? What is the legal position of the fund’s assets and how are they held in the local market?
“When determining risk it is done by fund, by strategy and ultimately by understanding who are the counterparties to the fund.”
O’Keeffe notes that from a cost perspective it’s likely to be a smaller impact on the managers’ fund performance when choosing SMT Trustees either for full AIFMD support or depo lite when compared to what many thought pricing might be only 9-12 months ago: “There will be more work involved for us with respect to cash flow monitoring in particular under AIFMD but nothing that will involve exorbitant costs to the manager. If a fund is delivering good returns, a small increase in terms of a few basis points shouldn’t have too much of an impact on a performing fund.”
Ultimately the cost impact to the manager will depend on the strategy and the type of assets being traded, and in which markets. In the fully integrated model the risk premium will be lower compared to the de-coupled model. When asked whether Deutsche Bank would ever refuse to support a manager if the perceived risks being taken in the AIF were too high, Hughes replies:
“Where we would take a view on the manager is where they are trading frontier markets, for example, and holding assets with prime brokers who are not approved on our platform. In such a scenario we might not be able to provide depository services for those specific markets.
“Illiquid assets like hedge fund side-pockets, real estate assets etc are strategies that are supported provided we can get comfortable with how they are held by the fund. It comes down to: what is the asset, where is it held, and who are the counterparties. That will determine the yes or no decision tree.”
As part of its oversight function to ensure a fund is trading within its investment guidelines Deutsche Bank has built a technology solution called dbDepository that monitors and controls the three core functions under AIFMD: oversight, safekeeping and cash flow.
“If all of a sudden on a Monday morning a frontier market appears in the asset base, and it’s meant to be a developed market LSE strategy, and where the manager has started using a custodian that we don’t have tagged against that particular manager, it will be flagged up as an exception. We’ll open up a dialogue with the manager to determine why it has happened,” says Hughes.
The open architecture model
At UBS Fund Services, the integrated model is fully supported to those AIFMs who would prefer to go that route but such a model will not necessarily be in the best interests of managers of a certain size who will benefit more from an open architecture model, says Byrnes. In his view, it makes sense to allow the manager to continue with the existing prime brokerage relationships, provided of course the prime brokers are supported on the UBS platform.
“We can facilitate an open architecture platform for prime brokerage appointments. This gives clients the flexibility to appoint the prime brokerage counterparts they need to work with which will add significant value to their business and that of their shareholders,” says Byrnes.
The open architecture approach is considered by UBS to be a more cost-effective framework to implement. UBS will work with a manager’s preferred prime broker(s) in order to implement a legal and operational framework commensurate with the framework it has in place in the UBS investment bank division.
“This framework is in line with other open architecture frameworks with respect to discharge of liability (to the prime broker under a sub-custodial agreement). Where that is not possible we will have an indemnification model in place with the relevant prime broker.
“We therefore don’t envisage that this model is going to be as costly as some of the headlines have predicted over the last 18 months. We think the costs are going to be negligible relative to the pre-AIFMD framework that has been in place in Ireland for Irish QIFs,” says Byrnes.
Provided the discharge of liability is acceptable to both the AIFM, the depository and the prime broker – who will under such an arrangement be responsible for the safekeeping of the fund’s assets (less unencumbered assets) – and the necessary disclosures are made, Byrnes sees this open architecture model as the one most likely to be adopted by the industry.
“In the event that model is not possible for whatever reason, and one needs to move to an indemnification model in terms of the depository managing its liability that will have a marginal cost impact to the manager but nothing too prohibitive compared to what they pay today. If, however, both prime brokers agree to the discharge of liability model then it will not be significantly cost prohibitive to the manager than the pre-existing Irish trustee framework for QIFs,” explains Byrnes.
Whether a manager chooses the integrated model or the open architecture model will largely depend on their size, whether they are a new or existing manager and the extent to which they use prime brokers.
One issue that managers were initially concerned about was how the appointment of a depository under AIFMD might impact their prime brokerage relationships. This though is very much a ship that has sailed thanks to the sub-custodial agreements for discharge of liability that are busy being put in place. What is of more concern is making sure that their depository will actually support their preferred prime broker(s).
“If managers don’t get on top of this soon they could find themselves in a situation where all their balances will have to be transferred to one particular prime broker if the other prime brokers they are using are not supported by the depository.
“We are looking to add more counterparts to our platform. This will develop over time and it’ll be the same for every depository operating under an open architecture approach,” says Byrnes.
With respect to the oversight of other assets (i.e. those held by the prime broker) and the custody of bankable assets, a depository has a duty under AIFMD to ensure those assets are ring fenced and to ensure that the AIF has restitution of such assets upon the failure of any particular counterpart.
“We are not looking to intervene in the day-to-day business of how a hedge fund manager interacts with their prime broker(s). We just want to make sure that in our role as the depository we can put a framework in place that addresses the requirements of Article 21 under the directive and that we can agree a framework with the prime brokers. If we can do that it should have very little impact on the daily operation of a hedge fund manager as long as they themselves are meeting the requirements as an AIFM,” adds Byrnes.
O’Keeffe points out that SMT is active in nearly 100 markets and has between 12 and 14 sub-custodial relationships, stressing that “we do not intend to impose our own custody network. If the AIFM has an existing relationship with a prime broker(s) and they wish to have SMT Trustees consider their appointment as a sub-custodian we will of course undertake due diligence etc but as we already have many prime brokers appointed as sub-custodians its also likely to be a faster process.
“We haven’t insisted that the assets at the primes are placed back in our own directly appointed custody network. Instead we’re happy to consider the appointment of others as sub-custodians. That may assist a lot of fund managers in respect of turnaround time too.”
One issue that has been actively debated among prime brokers and depositories for many months, but which appears to have been resolved centres on asset segregation. From the point of view of some depositories, as part of their oversight function they want full segregation right down to the underlying delegate level of the prime broker. This seems wholly impractical and unlikely to fly. It would interfere with the financing models in place, in particular the ability for a prime to pool clients’ assets into an omnibus account for rehypothecation purposes.
“Our view is that as long as the assets can be identified with the underlying delegate and we can identify those assets within our own systems we won’t look for asset segregation at the prime broker. We think it is absolutely not achievable. Even for a custodian, having segregation of assets for each and every client is something that would make the business model impossible,” comments Byrnes.
A lot has been written about the ability to support independent prime brokerage relationships under the depository provisions of AIFMD. However, maintaining an independent fund administrator could also prove to be important to managers and their shareholders.
The administrator’s role is vital in relation to cash flow monitoring. Unlike the prime brokerage sub-custodial arrangements, however, many depositories will likely prefer AIFMs to avail of both their depository and fund administration services under one roof. Many of the universal banks are well placed to support this. The benefit being that they run daily operating models for cash reconciliation. This data can then be fed directly for review as part of the oversight function. The minute the depository has to work with an independent administrator costs will rise because of the IT impact on aligning systems to handle third party data feeds etc. This will add extra cost to the AIFM.
At SMT Trustees (Ireland), O’Keeffe views the ability to support independent administrators as a useful value proposition:
“Who is watching the watchers? Who is truly independent in all of this? We work with a number of fund administrators totally independent of the SMT group, even though we have our own fund administration arm, and provide trustee and custodial services for funds that they act as administrator for.
“They are happy to work with us, there’s no conflict of interest. They bring clients to us and we act independently. It works well and it shows clients that there’s consistency of understanding. That we work with other administrators in direct competition with us really highlights the level of independence we can bring to the table,” says O’Keeffe.
Hughes concludes by saying that the process for managers to appoint Deutsche Bank as their depository is a quick and easy process: “We’ve got depository agreements that are compliant with each of the major fund jurisdictions – Luxembourg, Ireland, Malta. It’s then down to each manager’s lawyers reviewing the agreement documentation. So really it’s a case of how quickly the AIFM takes, rather than us as the depository, to get the agreement signed and sealed.”
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