This INDOS Financial article was first published by HFM Week and can also be read here (subscription required).
ESMA recently issued a Consultation Paper on asset segregation under the AIFMD.
The proposals will have a significant impact on prime brokers and depositaries but also managers and ultimately investors as well. Fundamental questions are being asked whether the changes enhance investor protection or simply put yet more pressure and cost on an industry feeling the burden of increased regulation.
The AIFMD requires EU alternative investment fund managers to appoint a single depositary for each EU domiciled alternative investment fund (AIF) they manage. Financial instruments held in custody should be held with the depositary in segregated accounts but depositaries may delegate the safe-keeping duty. Because most hedge funds depend on financing and asset servicing provided by prime brokers (PB), safe-keeping is delegated to the PB(s). The depositary must ensure that the PB segregates the assets of the depositary’s clients from its own assets, and maintains records and accounts to distinguish between assets of the depositary’s clients, its own assets and assets of its other clients.
ESMA recognises that a PB can maintain a common ‘omnibus’ account for multiple AIFs. PBs typically operate a single client omnibus account for all clients. Under UK client asset rules, the assets held in the omnibus account must be kept separate from the PB’s own assets. There is no physical segregation of assets but PBs maintain books and records to distinguish the assets belonging to each AIF. To date, PBs and depositaries have been operating on the basis that these books and records satisfy the AIFMD requirements.
ESMA main focus is the extent to which assets held in an omnibus account should either be only AIF client assets of the same delegating depositary or whether the omnibus account can hold AIF assets of different delegating depositaries. Either option would be a significant change for PBs because it would require treating AIF assets differently from other client assets, and managing multiple omnibus accounts. ESMA appears to have ruled out several other options including full segregation. It is unclear whether the proposals only relate to EU AIFs (full depositary) or whether they impact non-EU AIFs (depositary-lite).
What could this mean for investors, managers, prime brokers and depositaries?
The proposals are aimed at improving investor protection, yet the paper offers no analysis as to how they would have this effect. There appears to be widespread scepticism they will. Instead we are likely to see a significant increase in costs and operational risk, restrictions on market access, reduced operational efficiency, reduced competition and further pull-back from Europe by US managers and investors.
The most obvious impact will be on prime brokers – firms already under increased capital and business pressure from regulations such as Basel III. Multiple omnibus accounts will reduce operational efficiency and result in increased operational risk particularly around failed trades. The changes are likely to have an effect on a PB’s ability to re-hypothecate assets and the financing it is able to offer hedge funds because of the dilution of the pool of available assets. PBs could move to synthetic product access only in certain markets. Depending on which option is required, there is a risk PBs will restrict the number of depositaries they work with. This would result in reduced competition between depositaries and more concentration risk in the industry.
Managers will also be impacted. The guidelines will apply to managers as well as depositaries since the manager is responsible for ensuring compliance with AIFMD. Firms could see increased transaction and financing costs, restrictions on the markets and instruments in which they can trade, inability to place block trades and more operational complexity generally.
Depositaries may feel intuitively that the proposals provide a greater level of protection but in reality assets will still not be held under their control. It has taken a long time to agree terms between PBs and depositaries around indemnities and the discharge of liability. It is likely PBs would want to re-negotiate these terms and it may put pressure on the arguments used by depositaries to defend liability discharge.
The deadline for responses to the consultation paper is 31 January 2015 with final guidelines expected by the end of March. There is no mention of a transitional period but it could take some time for prime brokers to implement the changes.
Given the potential impact of the proposals on the industry, more clarity on how investor protection will be enhanced would be welcome to weigh up against the increase in costs which industry participants and ultimately investors will bear.