Esma backtracks on account segregation

The European Securities and Markets Authority (Esma) has backtracked on stricter rules for depositories that some critics had said would choke tri-party repo markets and prime brokerage.

As predicted in a Risk.net article last year, the European Securities and Markets Authority (Esma) has opted for minimum European Union-wide account segregation requirements under the Alternative Investment Fund Managers Directive (AIFMD) and Ucits V.

The move is opposed by France’s buy side in particular, but will be welcomed by intermediaries specialising in the reuse of collateral, some of whom had described proposals for tougher rules as “abject madness”.

The new measures are published as an opinion and Esma has invited EU institutions to consider legislative clarifications in the Ucits and AIFMD framework. The new rules would allow commingling in omnibus accounts at the delegate level of the assets of alternative investment funds, Ucits and other clients – although they must be kept separate from the delegate’s own assets, the depository’s own assets and the accounts of other direct clients of the delegate, including the accounts of other depositories.

“This is the result of Esma giving up on reaching a compromise,” says one Brussels-based lawyer.

Use of omnibus accounts will be subject to certain conditions, including: regular reconciliations; a block on assets being available for distribution to creditors of a failed entity; contracts ensuring a depository’s right to information from delegates; and limits to the reuse of securities.

Further mixing of assets will be allowed at the third custody level: sub-delegates will be allowed to operate omnibus accounts comingling all clients of all depositories and the depositories’ own assets – but excluding own assets of the delegate, sub-delegate and sub-delegate’s other clients.

In the July 2016 call for evidence, which put forward several options for proposed changes, French entities including asset management association AFG, asset manager Amundi and the Association of Securities Professionals backed Esma’s so-called “Option 1”, whereby institutions such as sub-custodians and prime brokers would be barred from mixing alternative investment funds, Ucits and other assets in the same accounts. Instead, Esma has accepted the view that segregation is costly and arguably confers no greater protection in an insolvency. “Only minimum EU-wide segregation requirements should be prescribed,” it says. National regulators are free to apply higher standards, however.

Esma also accepted arguments that rehypothecation – employed in tri-party collateral management, securities lending and prime brokerage – would be hindered if pooled omnibus accounts were prohibited. Alternative investment funds and Ucits would then be forced to lend their assets on a bilateral basis, a situation unwanted by borrowers because it requires multiple transactions to build a desired position.

It was feared that stricter asset segregation policies would also create problems, for example, in developing countries, where local custodians may not be able to offer with legal certainty segregation that is bankruptcy remote.

Most of the respondents to the consultation were trying to maintain the status quo

Bill Prew, Indos Financial

Legal precedent was the driving force behind French demands for stricter standards. Following the collapse of Lehman Brothers, a French court ruled in 2010 that RBC Dexia Investor Services and Societe Generale Securities Services should make investors whole, despite having no control over what Lehman did with the assets.

Under AIFMD, if a third party were to fail, the custodian could potentially have to replace collateral and/or assets within 27 days, before pursuing a counterclaim with an unknown outcome over a long period of time.

Prime brokers had argued that stricter account segregation would result in increased complexity in an insolvency scenario leading to a likelihood of greater delay in identification, reconciliation and release of client assets – as well as greater operational risk.

Others disagree with such a view, though. Thorsten Gommel, Frankfurt-based partner at consultant PwC, says: “Physical segregation greatly increases complexity and hence operating costs in day-to-day processes, [but] I don’t see it as slowing down the process to return assets to clients in the event of insolvency of a sub-custodian.” A more important factor, he says, is that in some jurisdictions insolvency administrators cannot release assets until it is certain all claims are based on undisputed legal title.

Bill Prew, founder and CEO of UK-based independent depository Indos Financial, counters that operational complexity increases when more accounts are mandated, but concedes: “If you’ve got a segregated account clearly in the name of the fund, in an insolvency situation less can go wrong in terms of identifying the assets and returning them. Most of the respondents to the consultation were trying to maintain the status quo.”

Some big buy-side players demand strict segregation unilaterally. Amundi currently insists delegates and sub-delegates of the depositories it uses separate out the assets of Ucits clients, alternative investment fund clients and other clients into three separate omnibus accounts – as well as separate out their own assets and the depositories’ assets. PGGM goes a step further and directs its delegates and sub-delegates to segregate assets on a fund-by-fund basis.

Asked if investor protection has been enhanced by Esma’s opinion, even supporters of the outcome are lukewarm. Jennifer Wood, global head of asset management regulation and sound practices at the Alternative Investment Management Association, says: “Is the opinion itself enhancing investor protection? That’s hard to say. I don’t think it’s hurting investor protection. I would call it neutral on investor protection.”

Also included within the scope of Esma’s consultation was how depository delegation should apply to central securities depositories (CSDs). That body of work drew a distinction between issuer and investor CSDs; only the latter – who compete with global custodians – will be treated as delegates.

However, Adrian Whelan, Dublin-based senior vice-president of regulatory intelligence at custodian Brown Brothers Harriman, says tagging investor CSDs such as Euroclear and Clearstream as delegates rather than market utilities will please neither EU depositories nor the CSDs themselves. “The industry will now need to re-engage on this point,” he says.