PB lobbying perceived to soften Esma on asset segregation

The two options offered by Esma in its consultation paper will make rehypothecation of AIF assets easier than if AIF-by-AIF segregation was mandated

Prime brokers may get off lightly if one of two options outlined in a consultation paper issued by the European Securities and Markets Authority (Esma) is implemented, according to some in the industry who question whether asset segregation requirements under the alternative investment fund managers directive (AIFMD) are at risk of being watered down.

In the paper, Esma proposes two solutions to asset segregation. Under the first option, the account on which the alternative investment fund's (AIF's) assets are to be kept by the delegated third party may only comprise assets of the AIF and assets of other AIFs of the same delegating depository. Assets of AIFs of other depositories would be considered as assets of the third party's "other clients".

Under the second option, however, a delegated third party holding assets for multiple depository clients would not be required to have separate accounts for the AIF assets of each of the delegating depositories.

Alex Harborne, senior analyst at London-based consultant Thomas Murray Data Services, says: "This was not really what was expected from Esma. Lobbying has clearly worked. It was thought that the two options put forward would be either option one from the consultation document, or segregation by prime brokers at sub-custodian level, AIF-by-AIF for each depository."

Harborne says it appears as if prime brokers have successfully argued that a delegated third party holding assets for multiple depository clients in a pooled account will have "line of sight" over all of their AIFs' assets.

He adds: "I imagine that the depositories will not be best pleased, as the two options offered by Esma will make rehypothecation of AIF assets by prime brokers easier than if AIF-by-AIF segregation was mandated, especially if the regulator goes for the option proposed in the consultation of allowing the prime brokers to have one ‘super omnibus' account holding AIF assets from all depository banks."

But Donnacha O'Connor, partner at Irish law firm Dillon Eustace, thinks it unlikely that AIF-by-AIF segregation would be required by Esma because Recital 40 in AIFMD states that delegates "should be able to maintain a common segregated account for multiple AIFs", which appears to permit omnibus accounts.

Jacqui Hatfield, partner at UK law firm Reed Smith, says "prime brokers will favour option two as the lesser of two evils. Option one will be perceived by stakeholders as unnecessarily restrictive and option two is likely to be favoured."

However, either way, she says the power is with depository banks as, irrespective of whether option two is permitted, in view of the liability issue, depository banks may push for option one in any event.

She adds: "If prime brokers want to act as sub-custodians of AIF assets, they will be forced to comply. Many are resigned to this already and have changed their models accordingly."

The prime brokerage industry expects it will have to increase pricing to clients if strict segregation requirements restricts its ability to hypothecate the assets posted as collateral by hedge funds and held on their behalf.

Speaking at the Second Annual Irish Funds Industry Association UK Symposium last week, Gareth Murphy, director of markets supervision at the Central Bank of Ireland and chair of Esma's investment management standing committee, says the issue of asset segregation within the depository chain under AIFMD "has been one of the most contentious issues of my tenure.

"The reason for this, I believe, is that there has been insufficient exploration and clarity around the costs and benefits of extra segregation of accounts at a depository and throughout the depository chain.

"In effect, we need more information about the costs of extra levels of segregation and the potential benefits of this, bearing in mind that this may, in fact, only become clear in the rare and unfortunate scenarios where a depository fails."

The consultation is open until January 30, 2015 and Esma aims to finalise the guidelines and publish a final report in Q2, 2015

Murphy told Risk.net: "When considering the benefits of additional segregation, there are detailed technical issues involved including a consideration of how local insolvency laws might apply to a depository or sub-depository. The aim of the consultation is to provide industry with an opportunity to provide detailed feedback and evidence on these issues so that Esma can deliver the right solution in the interests of investors of alternative investment funds."

Jean Guill, director-general of Luxembourg regulator Commission de Surveillance du Secteur Financier, says: "Let's now see what results the consultation will bring. We certainly encourage all stakeholders to make their voice heard."

One prime broker told Risk.net: "On first glance, this seems a sensible consultation. Prime brokers need to be agnostic to either option and offer segregated accounts to all clients. Clearly, with increased segregation there comes additional costs in running these extra accounts. Ultimately it is likely these will get passed back to the funds as an increased cost of doing business."