Digital Assets Report


Like this article?

Sign up to our free newsletter

Understanding the role of the depositary

Related Topics

There are a number of important considerations for a fund manager, especially a start-up, when it comes to selecting an onshore depositary to an onshore AIF. But before these are explored, it is perhaps worthwhile explaining exactly what the role of the depositary is under AIFMD, given that alternative fund managers have never had to use one before.

Safekeeping of the AIF’s assets

There are two parts to this. Firstly, providing custody of financial assets that are held directly by the depositary (i.e. stocks and bonds, options and futures). Secondly, performing record keeping and ownership verification of an AIF's assets, which are not required to be held in custody; i.e. private equity investments where the assets are owned and held in the manager's name. 

General oversight of the AIF’s assets

According to Suryanshu Mishra (pictured), Head of Hedge Fund Administration, Fund Services at Deutsche Bank, it is important that the depositary properly understands the AIF's valuation policies in order to effectively monitor them. This ensures that the policies are enforced and adhered to, in line with AIFMD and the AIF's governing documents (i.e. the Offering Memorandum). 

"There is a thin line with this as a lot of fund administrators often carry out this role but they do so in a different capacity. At the end of the day, the administrator will tend to accept an instruction from the fund manager when it comes to any exceptions from the fund valuation policy, but the depositary can go a step further and actively question the valuation policy and enforce it. 

"The other piece to oversight is monitoring transactions on an ongoing basis to again make sure they are in line with AIFMD and with the fund's governing documents. This might involve making sure that the AIF does not exceed leverage restrictions, for example, making sure settlement considerations for transactions are compliant with market standards, and finally, with regards to income for the fund, making sure dividend or accrual income is in line with regulation and the Offering Memorandum," explains Mishra. 

He says that the depositary has to understand every single facet of the fund strategy at the onboarding stage, ideally before the OM has even been finalised by the investment manager.

Cash flow monitoring

This is arguably the most important role of the depositary, according to Mishra. In summary, it involves having a regular line of sight into the cash flow of the AIF, ensuring that there is no deviation from the AIF's primary activities, and ensuring that investors' monies are paid into the fund's bank account. 

"That ties in with the two other primary duties of asset safekeeping and general oversight of the AIF. If the cash is consistent, and coming in and out of the correct bank accounts, that effectively offers an additional layer of oversight to protect the fund's investors," says Mishra. 

Indeed, the premise of AIFMD is to uphold investor protection and avoid a repeat of the Madoff scandal. As such, the depositary has a fundamental role to play. It is, therefore, imperative that start-up managers – or indeed those managers who run existing offshore vehicles but wish to offer a regulated fund to continental European investors – understand what to look for in a depositary.

Firstly, it's important to look at the authorisation aspect. Is the depositary appropriately authorised and regulated by the local Member State regulator? 

The next key criterion is financial strength. 

"I can't emphasise how important this is," states Mishra. "The depositary needs to have a balance sheet that is strong enough (not withstanding regulatory capital), to cope if there is a strict liability call and the strict liability hasn't been discharged to the AIF's prime broker(s) or sub-custodian. The depositary must always have a safety net in place in case of this. 

"Another important aspect is managing potential conflicts of interest. How does the depositary interact with the fund administrator with a level of objectivity? With the integrated model – where large financial institutions can act as both the fund administrator and depositary to the AIF – they have to functionally and hierarchically be segregated, from a data management point of view, so that the depositary really can provide objective oversight. 

"The initial due diligence of speaking to a depositary that is part of the same organisation as the AIF's fund administrator, understanding the processes, and doing a detailed walkthrough of how independence is maintained, is very important."

Managers are advised to also review the depositary's operating model. What is the frequency and quality of review around investment guidelines? Make sure the depositary actually has a way of monitoring the evolution of the fund. The appointed depositary should be constantly enhancing its cash flow monitoring operation as part of its key role.

Another key consideration is cost: a worry for any new manager. 

With an integrated model, whereby the depositary and fund administrator – and potentially even the prime broker – are part of the same broader firm, managers can benefit from economies of scale and get a total package cost that is likely going to cost less than appointing the fund administrator and depositary separately. 

"I also believe that managers should check a depositary's legal terms. Do they have up-to-date contractual arrangements as required under UCITS V Level 2 guidelines? And last but not least, future developments. Can the depositary keep up with the growth of new funds that it is elected to support? Can it keep up with regulatory developments? When selecting the depositary, managers need to think not only about what the depositary can do today, but what it can do over the next two or three years," comments Mishra. 

One way to check this is to ask questions about the depositary's views on future regulatory changes and how they plan to adapt to these changes. What is their level of engagement with local regulators? Make it an open dialogue not just a box ticking exercise. 

Strict liability & asset segregation

There is still work to be done in terms of establishing what the best practice should be regarding asset segregation and remains the million dollar question. 

Mishra says that at Deutsche Bank Fund Services the view is that ultimately the strict liability provisions of AIFMD will eventually require depositaries to work with prime brokers with a full discharge of liability; meaning the prime broker will be responsible for any loss of assets that they are responsible for safekeeping.

"That has to be the case and become the de facto model in terms of how depositaries interact with prime brokers. But this will involve a lot of detailed legal negotiations between the AIFM and the prime brokers and between the AIFM and the depositary in a tripartite arrangement. The AIFM needs to budget adequate time and effort to get this arrangement in place with the depositary and prime broker," says Mishra.

As for the asset segregation point, at present prime brokers can continue to pool all of the AIFs' assets together into their omnibus account without individually segregating them. But Mishra believes that any parties to whom an AIF's assets have been delegated for safekeeping should be subject to the same asset segregation requirements that apply at the depositary level. 

"The standards of asset segregation for the depositary need to be applied to everybody in the value chain. That means the prime brokers will eventually be unable to operate traditional omnibus accounts and will need to provide full segregation, as is now the case for depositaries under UCITS V," says Mishra.

Like this article? Sign up to our free newsletter

Most Popular

Further Reading