Last year there was considerable angst and uncertainty among hedge fund managers. Central to their concerns was the impact appointing an independent depositary under AIFMD would have on their existing prime brokerage relationships. Twelve months on, however, and much progress has been made to alleviate these fears, with Mike Hughes (pictured), Global Head of Fund Services at Deutsche Bank, referring to the period as a ‘game of two halves’ (in World Cup parlance).
“In the latter half of last year there was still a lot of uncertainty. Where would the depositary fit in terms of the overall client relationship? The strongest relationship a fund manager has had, historically, has been with its prime broker and there was a view that depositaries might become a manager’s new best friend.”
“Over the last six months, however, a lot of good sense has been brought to the market. The discussion has involved practitioners (people who actually know how this model works rather than just spokespeople) coming together to develop and agree on the operating model for funds in unison with hedge fund managers, prime brokers and custodians. It has been a much more pragmatic approach.
“We’ve reached a level in the weeds that we’ve never before seen under AIFMD,” comments Hughes.
The upshot here is that managers can take reassurance that the last thing depositaries are going to do is usurp prime brokers as the key client relationship. Indeed, Deutsche Bank went on record as far back as two years ago saying that AIFMD would not upset the apple cart. The prime brokerage model remains fully intact. Of course, there are subtle contractual differences given the discharge of liability agreements that need to be put in place with depositaries, but as Hughes stresses, “the principal role of the prime broker has not changed”.
Integrated versus de-coupled model
The integrated model that Deutsche Bank has developed to support AIFMs is preferential – especially to smaller managers – because the AIF’s risk can be contained within the four walls of the bank. This offers an attractive cost benefit.
“I definitely believe that for new managers, or managers who aren’t yet bulge bracket, they are looking closely at the integrated model. We do all the regulatory reporting, trade repository reporting and all the administration and custody work under a single umbrella. It brings better economies of scale than were the manager to appoint individual counterparties,” says Hughes.
Indeed, a white paper written by Deutsche Bank last year entitled ‘Charting a smooth course through AIFMD implementation’ stated: “We believe that AIF managers would be best served by consolidating their business with depositaries equipped to work with their existing prime brokers and that can also act as fund administrators, cash managers, transfer agents, and sub-custodians within a framework of appropriate ‘Chinese walls’ and segregation of duties.”
There was a view two years ago that such a model might not have been favourable because of conflicts of interest but that view has since dissipated according to Hughes.
“Managers are looking to bundle their risk and work with strong counterparties. The integrated model has worked very well for us and has been well received,” he confirms.
The de-coupled model is better suited to larger managers that want the flexibility to maintain existing multiple prime brokerage relationships. Deutsche Bank has developed a standardised approach and worked tirelessly over the last year to sign discharge of liability agreements with the leading prime brokers on the street, dispelling any fears that appointing a depositary under AIFMD would somehow push managers into adopting a single prime broker model.
“That just has not happened. Our depositary model fully supports managers who wish to continue with their multi prime relationships. We already have a number of large clients where that is indeed the case,” says Hughes.
The appointed depositary has three core tasks to perform under the directive:
• Cash monitoring
• Asset safekeeping
• General oversight (compliance)
Last year, Deutsche Bank invested significantly to build out its dbDepositary solution to handle these core activities, in addition to a fourth key function: calculating the liability of the depo. Under a ‘depo lite’ solution, non-EU AIFs must still appoint a depositary but the depositary is not held liable in the event that any losses are sustained; a full depositary solution entails strict liability for financial instrument and other losses that might have been avoided through operational oversight.
“The underlying core service between full depo and depo lite is no different. It’s just that under the full depositary model we have to handle a fund’s liability. With dbDepositary we have a single operating model and technology framework. Our risk reports then allow us to determine a fund’s liability under full AIFMD,” says Hughes, noting that cash monitoring has proven to be the most challenging role undertaken by the depositary thus far.
This is largely down to the complexity of piping data from various counterparty banks in order to perform cash monitoring effectively.
“We thought the oversight function would be the most challenging but you can’t provide effective oversight unless you’ve got the correct reporting in place on securities accounts, cash accounts and prime brokerage accounts containing leveraged (or rehypothecated) assets. There are so many bank accounts involved. A single fund might have two prime brokers, two share classes; that’s already four separate bank accounts that all need to be reported on,” says Hughes.
With the end of the transposition period imminent (22 July 2014), a bottleneck is starting to build as local regulators deal with AIFM approvals; a clear sign that managers are willing to embrace AIFMD and do the right thing by their investors. Moving forward, Hughes believes that once a suitable number of AIFMs are up and running in Europe the biggest challenge for AIFMD will be to agree on Annex IV reporting standards.
“There is definitely a need for a level playing field. It is one of the principal unanswered issues with respect to Annex IV reporting. The interesting point about Annex IV is that the filing is largely numerical. If there are pre-defined calculable fields it will make it easier to standardise reporting across different Member States but we remain a long way away from that today. The reporting regime under Annex IV needs to mature. Once we have a reasonable number of AIFMs – say 100 AIFMs across six key Member States – reporting data, then I think we’ll see those Member States come together to review the differences (and try and reach a common reporting standard).”
Consider this: under Form PF managers must answer around 30 questions. For CPO-PQR reporting it is 22 questions. Under AIFMD, Annex IV contains 301 questions. Multiply that by 100 AIFMs and getting regulators to meaningfully interpret 3,000 data points, which will vary greatly depending on fund strategy and trading instrument, and the task ahead is onerous. After all, there is no point having all of this reporting data if it cannot be actionable.
“There needs to be an aligned view when managers start reporting under Annex IV because without one nobody benefits. The detail under Annex IV is way in advance of anything a hedge fund manager has ever seen before,” says Hughes, agreeing that the lack of a reporting standard remains the 800-pound gorilla in the room.
When asked what managers need to look for when assessing who to appoint as their depositary, Hughes concludes by saying:
“They need to look at a depositary’s ability to support them on a global basis, to have an open architecture model in place, to report in a streamlined way and to assess how effective it is at dealing with complex strategies: there are some depositaries that are starting to push back on certain fund strategies. We are not one of those.”
