By Gavin Byrnes, UBS Fund Services – The Alternative Investment Fund Managers Directive (“AIFMD”) has caused much rancour and debate over the last few years but at last the end is in sight. Some of the more challenging aspects of the Directive have centred on the Remuneration and Depository provisions, which the industry as a whole has struggled to understand and establish within their businesses.
Below are some of the practical challenges and considerations that managers should already be addressing pertaining to their Depository arrangements; in particular Article 21 of the Directive, which is still a provision where managers face complex challenges.
Strict liability has been the most contentious aspect of Article 21 under the Directive; all managers should be engaging with their Prime Brokers and Depositories to develop a workable framework. Although much of the Prime Brokerage industry is accepting a discharge of liability, the argument for demonstrating an objective reason to support such a discharge needs to be carefully considered.
Some Depositories are driving their clients towards a vertically integrated model with their own Prime Broker providing the necessary financing while others appreciate that an open architecture approach is required to ensure costs are minimised and managers can diversify counterparty risk. Services such as financing, risk reporting and other prime brokerage orientated ancillary services form the basis of this objective reasoning as without them it is difficult, if not impossible, for a hedge fund manager to operate. Separating the assets from the Prime Broker with Depositories will only further exacerbate the issue and contribute to increased operational cost, technology and integration difficulties as well as increased financing costs.
The other measure being considered to address the strict liability issue is the indemnity model between a Depository and a Prime Broker. Most Depositories who will consider appointing a Prime Broker as a sub-custodian will favour the discharge of liability model but there may be instances whereby this is not possible and an indemnity framework will be the only other option with the exception of placing all long assets with the Depository. Regardless of the model implemented, it is of paramount importance that managers are forcing this discussion with their Depositories and Prime Brokers. Without a deep level of engagement, the manager’s ability to run their business and mitigate any significant negative consequences will be difficult to achieve.
The industry post-Lehman has already moved to address the counterparty risk imbalances that existed in the system. This has led to the development of Custodians offering Prime Custody type solutions or Prime Brokers offering a model where unencumbered assets are separated from the primary margin accounts. The Directive has further addressed this aspect of the debate whereby any delegate of the Depository must segregate the assets of the Depository’s clients from its own assets and from the assets of the Depository in such a way that they can at any time be clearly identified as belonging to clients of a particular Depository. This has caused much debate as to the levels of segregation with some Depository participants determining that it is virtually impossible to ensure such segregation without holding the assets within their own sub-custody network.
This approach is quite conservative with a more balanced argument being that the Depository must at all times be able to “identify” these assets. Many Prime Brokers in the UK today already implement an equivalent requirement under the Financial Conduct Authority (FCA) CASS Rules and the argument here is that the identification process is a record-keeping and reconciliation requirement rather than a finite asset segregation requirement all the way to the underlying delegate of the prime broker. Either way, Depositories have different views on how this arrangement should be implemented and it is critical that managers ensure that this particular aspect is addressed at the earliest possible stage.
The oversight duties under the Depository framework are very similar to the Irish trustee model which has been the prevalent framework in place for the Qualified Investor Fund (QIF) regime, now called the Qualified Investor Alternative Investment Fund (QIAIF) under the Central Bank of Ireland AIF rulebook. This is more of a fiduciary role whereby the Depository must oversee all the activities of an AIF and ensure that they fulfil all the requirements as set out under the Directive. It is important that all managers address the requirements as this could impact the day to day operations of their business.
Each Depository will have a different set of standards to fulfil their obligations and managers that work with more than one Depository may find themselves in a situation whereby they are supporting multiple reporting requirements further complicating their business. The smaller the manager the more important it is that they engage with their Depository and fully understand how this may impact their day to day operations.
Cash Flow monitoring
Cash Flow monitoring is an extremely challenging aspect of the Directive for Depositories who have struggled to determine how they can implement an operating framework to support this requirement especially where a prime broker has been appointed as a sub-custodian. There have been arguments put forward that the cash flow monitoring requirements will force managers to implement vertically integrated models (i.e. appoint an Administrator and Depository from within the same group).
The argument is that the Depository can rely on the reconciliation procedures in place with the administrator to support its verification of all cash flows within the AIF. To rely upon an independent Administrator from outside the same group as a Depository would be a risk that many Depositories may not be willing to bear. This has led to much debate and it is important that managers are discussing with Depositories what their framework is to support the cash flow monitoring requirement and whether they can work with a third party Administrator.
The Depository Lite regime is actually the most pressing aspect under the Directive as the impact is far wider given the number of offshore funds managed by European managers as compared to European funds. The central difference with the lighter regime is that the strict liability standard does not apply and in certain instances the core functions as outlined above can be performed by one or more entities (this is the position taken by the FCA in the UK).
The same practical challenges exist but more relating to the cash flow monitoring requirement given that the majority of Prime Brokers will act as the custodian of the assets with most receiving the necessary licenses to fulfil this function. It is important that managers fully understand the oversight requirements as this will be a new concept for offshore funds in general. It is also very important that the cash flow monitoring can be arranged in a way that satisfies the Depository should a third party act as the Administrator.
It is clear that a single approach across each and every manager will be difficult to achieve. The industry needs the support of the Depository and Prime Brokerage community to work with managers and find a model that best fits the needs of their business while also ensuring that all aspects of the Directive can be fulfilled.
Whether this will lead to a vertically integrated or an open architecture approach is yet to be seen. We are confident that an open architecture model is the most sensible approach and one that will ensure the ability of our clients to manage money while ensuring that costs are in some way mitigated for shareholders.