This INDOS Financial article was first published in the latest edition of the AIMA Journal.
The depositary model, introduced in 2014 for many funds under the EU’s Alternative Investment Fund Managers Directive (AIFMD), is now firmly enshrined within the industry. The appointment of a depositary was not initially met with support among the alternative investment fund manager (AIFM) community, but many now recognise the value in the extra level of oversight being undertaken.
Equally, institutional clients, some of whom have lost money in the past through operational failings and frauds in the industry, have continued to welcome the additional protections which depositaries bring.
Independent depositary INDOS Financial looks at some of the major trends and developments that have impacted the depositary business over 2017, and explores what 2018 may hold.
The Independent Depositary Model Grows
As an independent depositary, INDOS has experienced solid growth in 2017 driven by several factors. Having seen fund launch activity fizzle out in the aftermath of Brexit and the uncertainty that followed, 2017 has seen a pick-up in start-ups coming to market. Whether this is a sign of renewed confidence in the fund management industry is unknown, but it represents a noticeable turnaround and it is a welcome boost. However, this must be tempered as several AIFMs have closed due to a combination of challenges with asset raising, rising costs, regulation, and market conditions.
Increased non-EU/ third country manager interest in soliciting money via NPPR (National Private Placement Regimes) in some EU markets has also increased demand for depositary services. This is partly because AIFMD equivalence discussions with third countries have stalled since Brexit prompting some non-EU managers to raise capital via the NPPR route, instead of holding out for passporting rights. While the registration process in some countries such as Germany and Denmark can be time consuming, several INDOS clients in the US and Asia have been rewarded for their efforts raising significant sums of institutional money.
At the same time, fund managers with existing depositary arrangements have continued to re-evaluate their provider relationships. This has arisen due to conflict of interest concerns at managers who are increasingly sceptical about whether depositaries affiliated with fund administrators, which represents most firms in the industry, can carry out their roles and duties without bias, unintentional or not. As such, some managers are questioning whether affiliated depositaries can offer the same value as an independent firm.
The decision to switch depositary providers is also a consequence of managers seeking improved service delivery. Several managers have reported that engagement by depositaries has been piecemeal, while others complain of basic fund administration errors being overlooked or not flagged for further scrutiny.
Institutional investor due diligence teams are also becoming more vigilant and focussing on the role of the depositary. Managers that have taken a “tick the box” approach to the depositary requirement are facing increasing questions. Given the swing in the balance of power from manager to investor over recent years, firms need to have a well thought out strategy to address these investor concerns.
Along with investors, fund directors are more active and vocal than they were a decade ago, with many now undertaking thorough assessments on service provider performance. Directors are comparing the service quality they receive from different depositaries across their funds. Given their fiduciary responsibilities, directors want to see depositaries offer real value and demonstrate they can be trusted to bring issues to their attention.
Directors are therefore taking more interest in what the depositary is doing and challenging the manager on their selections, resulting in an upswing in fund houses changing providers at the behest of their boards. Independent depositaries, which regularly engage with board directors, alert them to fund-level problems and exhibit sound judgement will be the chief beneficiaries.
This increased focus on depositaries has also partly been prompted by regulation. As far back as 2013, the Financial Conduct Authority (FCA) conducted reviews into asset managers’ outsourcing arrangements and specific attention was paid to how firms were effectively overseeing third-party relationships. Following this year’s FCA Asset Management Market Study (AMMS), managers are now facing scrutiny from the regulator about how they deliver value for money across the value chain including fund service providers, while senior managers will also become subject to greater accountability through the Senior Managers & Certification Regime (SMCR) later in 2018.
Depositaries – like other fund service providers – are also being asked to show that they have effective controls to manage IT and cyber security risks in addition to evidencing that their processes and controls more broadly are subject to independent review. Surprisingly, few depositaries undertake SOC 1/ ISAE3402 controls assurance reviews but are coming under pressure to do so.
Considerations for 2018
Fund managers are clearly facing some challenging regulatory headwinds going into 2018. On January 3, 2018, the Markets in Financial Instruments Directive II (MiFID II) will impose a range of new obligations on fund managers, with provisions around product governance, transaction reporting, bans on inducements and restrictions on using commissions to buy sell-side research.
Managers will then have to prepare for the General Data Protection Regulation (GDPR) which comes into effect in May 2018, and will require firms to ensure robust and thorough safeguards around how client and other personal data is used and stored. Both MiFID II and GDPR are significant pieces of regulation which require a lot of resources and focus from fund managers. Once managers have attained MiFID II and GDPR compliance, they will begin re-evaluating their depositary relationships and consider a change in provider.
AIFMD originally included a requirement that it must be reviewed by the European Commission by 22 July 2017. The European Commission has now started this review. Its purpose is to ascertain whether AIFMD’s initial objectives have been met, but also to qualify its impact on the alternatives industry and its institutional client base.
There are several areas that the alternatives industry would like to see reviewed and improved namely the introduction of more meaningful AIFMD leverage measures, more standardisation of cross-border marketing, and simplification of the Annex IV reporting requirements among others. The current depositary-lite model will continue to apply, despite initial expectations that it would be phased out from mid-2018.
The impact of Brexit on AIFMD and the depositary requirements is the biggest elephant in the room. The UK regulator has given no indication that it intends to roll back on AIFMD. The depositary is viewed by the regulator as a cornerstone of good fund governance. It is also supported by the investor community and taking away these protections would be a regressive step, potentially harming the UK’s reputation as a well-regulated international market and undermining its long-term ambitions to obtain equivalence with the EU.
Irrespective of what Brexit looks like, INDOS Financial believes the depositary requirement is here to stay.