Depositories ponder size of capital requirements for AIFMD liability
Capital punishment
Depositories will be liable for losses to customer assets under AIFMD, potentially creating a huge exposure for these firms. There is uncertainty over how this risk should be priced and how much capital to hold against the exposure
The decision four years ago by Group of 20 leaders to require all standardised derivatives to be cleared through central counterparties (CCPs) prompted regulators to think hard about the implications for bank capital. Clearing members are required to contribute money to each CCP’s default fund, but this could be lost in the event of the default of another clearing member and its clients. Worse, the bank might be called upon to top up its contribution – an exposure regulators felt could not be ignored. How this should be capitalised is an issue the Basel Committee on Banking Supervision has been wrestling with since 2010, with the most recent consultation document published in June.
A similar sort of response may be needed for a controversial requirement under the European Union’s alternative investment fund managers directive (AIFMD), some participants claim. The new directive, which came into force on July 22, requires alternative investment funds (AIFs) to appoint a single depository – and compels that depository to make good any losses to investor assets held within its own custody network or by third-party sub-custodians. The requirement has been fiercely contested by depository institutions since it was first mooted in 2009, not least because it creates a potentially huge liability for the firms.
A source close to the European Commission (EC) says that as a result of bank regulation and, more specifically, with the Capital Requirements Regulation (CRR), there is a consistent set of requirements for European banks that sets out how much capital banks need to cover the operational risk of all of their activities. The fourth Capital Requirements Directive (CRD IV) and CRR implement Basel III in Europe. “These capital requirements cover custodian activities, and they cover the risk of failed or inadequate internal processes as well as external events,” the source says. National supervisors are also able to require banks to hold additional capital under Pillar II of Basel III if they feel certain risks are undercapitalised.
But custody banks say they have been struggling to calculate and price the extra risks – and decide exactly how much capital should be held against the exposure.
Prime brokers Prime brokerage is included under the custodian liability for lost assets. In a worst-case scenario, if a prime broker were to fail then the custodian could potentially have to replace the collateral and/or assets and pursue a counter-claim with an unknown outcome over a long period of time. Many believe that depositories are, in effect, being asked to insure the asset management sector against all Lehman-style or Madoff-like disasters and will be liable for losses due to acts committed by counterparties they have no control over and even those by counterparties they did not appoint. Where assets are lent out but title is retained, they remain assets of the AIF and subject to strict liability by the depository. Where transfer of title takes place and collateral is received by the fund manager, strict liability will need to be determined by lawyers as this can vary by market and counterparty. Getting ‘look through’ over the records of prime brokers may prove challenging as custodians ask to examine their books and separate out positions for a particular AIF which may be held unsegregated in pooled accounts at a prime broker’s intermediaries. In a default scenario where assets are pooled, mutualised losses with haircuts on securities aggregated pro rata would be borne by all clients in the pool. In those circumstances depositories would pick up the tab to make clients whole. Prime brokers will therefore be confronted with demands to change their accounting models to adopt a level of segregation they are not used to implementing. Subsequently, the size of the pool of available assets will be reduced and the pool will become more segregated, creating inefficiencies in the prime broker’s model. Florence Fontan, head of segment, asset managers, at BNP Paribas Securities Services, says: “If all the assets are comingled together then we will require a full discharge. That implies if something happens to the assets the AIF will have to go after the prime broker directly and not after the depository bank. The strict liability is transferred to the client.” However, Nicola Smith, chief executive of Helvetic Fund Administration in Gibraltar, disagrees that strict liability can be transferred. She says: “The liability will rest with the depository and it will be down to them whether the agreement with the broker is enforceable or not.” AIFMD allows for depositories and prime brokers in the same institution but they must be operationally separated by Chinese walls to avoid conflicts of interest and, if prime brokers are rehypothecating collateral received from AIFMs, appropriate permissions must be in place. Bill Prew, founder of independent depository Indos Financial, is certain that, at least initially, prime brokers will look to retain assets in their existing sub-custody networks and provide an indemnity to the depositories for loss of assets, as they do wish to adapt their models. A number of fixed income clients are moving towards industry-standard International Swaps and Derivatives Association-type bilateral trading relationships as opposed to prime broker arrangements, with collateral posted on a title-transfer basis under a credit support annex-type arrangement or global clearing agreement, says Pete Townsend, head of hedge fund solutions at BNP Paribas Securities Services. He says this approach can de-risk the operating model under which the fund operates. |
Losses would typically emerge due to operational failures or fraud by a custodian or sub-custodian. Under CRR, “operational risk” means the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events, and includes legal risk. CRR allows banks to use their own operational risk measurement systems to quantify the depository risk but does not drill down deeper into the exact metrics that should be applied.
Some in the custody world are calling for a generic model. “Normally, what happens in the banking world, if you’ve got a liability, the people in Basel will give you a formula to calculate the capital requirements you need to set aside against the risks that you’re running for that potential loss. For example, they borrowed credit risk calculations from banks and applied them to CCPs. But that hasn’t happened here. What we’ve got is a new liability that the custodians have to work out for themselves so the approaches could well be inconsistent,” says Tim Reucroft, director of investor services at consultant Thomas Murray.
Etienne Deniau, head of business development, asset managers/asset owners at Société Générale Securities Services (SGSS), agrees it would be helpful for regulators to set a standard formula for capital requirements to cover depository liability and that the industry should push for this. It would show, he says, that the biggest risk factor would be prime brokers (see box below) and the sub-custodians they select.
However, the rapporteur of the AIFMD says that the risk is too complex for a generic model to be applied. Jean-Paul Gauzès says: “It seems difficult to include the notion of responsibility in a mathematical formula. This is a matter of judgment that depends on the circumstances of the case.”
That does not necessarily help banks calculate the size of the potential liability, or how to price this in for client business. One thing is for sure, though – clients will see higher costs as a result. An impact assessment published by the EC in December 2012 predicts “excessive operating costs” for depositories due to the need to “foresee and avoid all sorts of risks related to all events that occur at the sub-custodian level”. Those additional costs will undoubtedly be paid by investors, the EC acknowledges.
According to a survey conducted in June by Multifonds, a Luxembourg-based software provider, 41% of respondents expect depository costs to increase by between five and 25 basis points (bp). Mathieu Maurier, global head of sales and relationship management at SGSS in Paris, agrees with that ballpark figure, adding that he has seen estimates of between 8bp and 20bp from consultants and competitors.
There is still a lot of uncertainty, though, and no-one really wants to make their approach public. “Banks are holding their cards very tight in this area. There is little involvement from external consultants at this point in time, as it is a completely new area. For some custodians it is such a question of their very existence that they would rather keep discussion of it very secret. Not many banks are tendering this type of consulting work,” says Thorsten Gommel, a partner at PwC in Frankfurt.
The AIFMD makes fundamental changes to the depository liability. Essentially, the depository is liable for any losses to investor assets, both within its own custody network and any third-party sub-custodians appointed by the depository, unless it can prove the loss was caused by an external event beyond the reasonable control of the depository. An event is deemed to be external if it is not the result of any act or omission by the depository or third party. However, the depository would still need to prove the loss was beyond reasonable control and there was nothing it could have done to prevent it. Importantly, the burden of proof is reversed and the depository has to show that it was not negligent in the process that gave rise to the loss.
To outsource or not? Where valuations are concerned, custodians find themselves caught between a rock and a hard place. Under AIFMD, the depository will have to oversee net asset value (NAV) calculations and look at significant movements in the NAV components. The depository should ensure valuation procedures are implemented through sample checks or by comparing the consistency of the change in the NAV calculation over time with that of a benchmark. AIFs can track their own specific or customised benchmarks though, meaning custodians would need to replicate them. It should be noted that the International Organization of Securities Commissions’ (Iosco) final version of the Principles for Financial Benchmarks, published on July 17, backs down from requiring index providers to make public the data necessary to replicate benchmarks (www.risk.net/2284444). Valuations could be outsourced to a third party but, given custodians retain fiduciary responsibility for negligence, there may be a move to bring this function in-house. Depositories, or asset managers themselves, can take on the valuation role as long as it is functionally and hierarchically separated by appropriate Chinese walls. However, London-based Tim Reucroft, director, investor services at consultant Thomas Murray, says the valuations may prove challenging for some custodians without prior experience in asset classes such as real estate, private equity and derivatives. He says: “So as well as being good accountants, custodians have got to be pretty good investment banks.” Pete Townsend, head of hedge fund solutions at BNP Paribas Securities Services, agrees: “We see the value in employing people with specific domain expertise to value certain asset classes and we are working through the implications of that. We also think that there are certain asset classes that are hard to value and there are specialist firms best placed to do that.” The appropriate source from which to obtain private equity and real estate valuations might be the auditor of the asset itself, although it would not be cost-efficient to pay the auditor to perform a full audit of the asset according to the frequency of the NAV, which might be quarterly, for example, resulting in four audits a year. Likewise, more due diligence will be required on outsourced functions such as transfer agents, registrars and fund administrators, while at hedge funds – in order to overcome shortcomings in how performance fees are calculated – equalisation calculations are used and depositories must get their heads around these as they are likely to differ by fund. |
So, if an investor loses access to its assets because a third-party sub-custodian collapses and the local jurisdiction has not implemented rules on segregation, it would be deemed an external event beyond reasonable control. In contrast, if it turns out the third party simply had not implemented segregation rules properly, the depository would be liable.
The loss would also have to be permanent, rather than a temporary freezing of assets. Those assets might no longer exist because of an accounting error, falsified documents or fraudulent conduct – in each case, the depository would be liable.
The obvious implication is that depositories will need to conduct thorough due diligence on their sub-custodians and will have to continue to closely monitor their activities on an ongoing basis. That’s not a bad thing, according to Tilman Lueder, the head of the EC’s asset management unit. “You could have depositories applying greater diligence to their sub-custody networks or integrating sub-custodians into their corporate group, therefore allowing a seamless cross-border service. A decent liability standard has often proved a trigger to a better and more competitive service,” he says.
But it is likely to require significant changes to the systems at some depositories, participants say. Firms will be required to monitor all cashflows and control and audit fund manager responsibility in terms of subscriptions, redemptions, valuation of shares and units, instructions, timely settlement of transactions and income distribution. This is a move away from the original expectation of monitoring cashflows for reasonableness. Independent capture, recording and monitoring of transactions is now a necessity, participants say. And some firms are further ahead with this than others.
One option may be for depositories to pull out of certain, riskier markets – a route many participants expect custodians to take. According to the recent Multifonds survey, 44% of respondents expect depositories to reduce support for certain asset classes, while 41% expect less support for some geographies.
Deniau says there are some countries Société Générale (SG) does not list in its global custody service: “If we have a fund that wants to invest in a risky country, like for instance in Ivory Coast where the SG subsidiary was briefly nationalised in 2011, we exclude our liability from that market. We have not had to do this through the AIFMD process yet, but we would have to get our sub-custodian to take the responsibility of asset restitution.”
That touches upon another option open to depositories – contractually delegating the liability to sub-custodians. AIFMD does allow this, but the delegate must be able to fulfil the same conditions and obligations as the depository. Even then, the delegation of the liability can only occur in certain circumstances. The depository must prove there is an “objective reason” for the shift and that it is in the best interests of the AIF or its investors.
A question of domiciles AIFMD requires AIFs to be in the same jurisdiction as their depository and will reinforce Dublin and Luxembourg as established hubs for back-office operations at the expense of locations such as Malta that, despite success in attracting funds to the island, has not managed to persuade custodians to set up in great numbers. There are transitional rules until 2017 to allow the AIF to have a depository elsewhere, but AIFs may have to re-domicile or custodians set up satellite offices unless the requirement is relaxed. Ucits VI, meanwhile, will introduce the notion of a passport for a depository, allowing cross-border flexibility. A July 2012 report from consultant Deloitte found 61% of managers claim AIFMD will affect their choice of domicile while, according to a Multifonds survey, the UK and the Channel Islands are also likely to benefit from funds choosing to re-domicile to an onshore location. It should also be noted that for offshore funds managed by EU managers a lighter-touch depository regime applies that does not include strict liability. |
As such, many are nervous about attempting it. Pete Townsend, head of hedge fund solutions at BNP Paribas Securities Services, says: “Irrespective of whether we put in place an agreement so that a sub-custodian indemnifies us for any loss, or our restitution obligation is discharged to the sub-custodian or prime broker, we still face the issue that we are responsible for performing oversight and control over that entity and if we do not then we could be construed to be still liable. For us this remains an open question.”
One global product head for alternative funds at a custodian told Custody Risk: “This is a question that vexes us significantly. I don’t want to find out the meaning of ‘beyond reasonable control’ in front of a judge.”
Along with enhanced monitoring of sub-custodians, depositories will need to get a handle on the potential size of their liability, which is likely to be extremely complex. Firms should be able to establish the probability of default of their sub-custodians and use established credit models to calculate any capital implications. But the liability would primarily arise as a result of operational losses – fraud, accounting error or technology glitches. The problem is that operational risk loss data is sparse at best.
Some banks believe they have arrived at a number they are comfortable with, but that number suggests regulators will need to look at minimum capital requirements for depositories, says the global product head for alternative funds, who adds: “We’ve come up with some numbers, and we are understanding the extent to which any capital should be set aside against it,” he says.
“The initial capital requirements under the Capital Adequacy Directive to set up as a depository amount only to about €800,000. It’s metaphorically a round of drinks. They are signing up to contacts that, in the event there is a loss, they do not have in any shape or form the capital base to recompense the investors. Any fund that appoints one of those types of entities needs to think long and hard.”
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