The last 12 months produced an eclectic range of challenges for fund managers to deal with. Aside from traversing various macroeconomic and geopolitical uncertainties, many were preparing themselves for further compliance obligations, a number of which have been or will be implemented over the course of 2018. INDOS Financial, the leading independent depositary provider to the alternatives industry, looks at what the year ahead may have in store for the asset management community.
AIFMD 2: A Review Begins
Article 69 of the AIFMD compelled the European Commission (EC) to begin a wide-ranging review of the Directive in July 2017, assessing its impact and effectiveness at achieving its stated objectives. Since then, a global consultancy has been appointed to undertake the AIFMD review, and it is currently soliciting industry comments and opinions from across the EU and a handful of designated third countries, which will form the basis of a report submitted to the regulatory authorities.
The outcome of the review is unknown, although industry professionals have urged EU regulators to introduce more meaningful measures around leverage, standardisation of cross-border marketing rules, and simplified Annex IV reporting requirements. It is entirely possible that such amendments to AIFMD could be proposed although this is unlikely to materialise before 2019.
The Preservation of Depositary-Lite
The depositary-lite model, which applies to EU based AIFMs marketing non-EU AIFs in the EU, was historically viewed as being a temporary solution during the interim period between AIFMD’s introduction in July 2014 and the switching off of national private placement regimes (NPPR) in 2018. NPPR will continue as the only route for marketing such funds in the EU as will the existing depositary-lite requirements. This is because there has been limited progress around finalising the extension of the AIFMD marketing passport to non-EU third countries, a key criterion for transitioning away from NPPR over time.
Lack of progress around extending the passport to third countries and the announcement of recent proposals potentially encumbering delegation have ignited tensions in the Asia Pacific (APAC) region. These actions could deter third country managers from launching AIFMs and UCITS and instead adopt more readily their own domestic fund passporting schemes. Regional passporting schemes in APAC, which are still in their infancy, may borrow from UCITS and AIFMD, including the depositary and depositary-lite concept, as they increasingly evolve and mature.
Flaws with the affiliated depositary model and the importance of the independent depositary
Depositary independence is being increasingly demanded by managers, fund directors and end investors as they look to break down the potential conflicts that exist with depositary providers affiliated with fund administrators, something which presents an inherent conflict of interest in their service provider oversight role. As a result, managers will continue to switch from affiliated providers to independents such as INDOS.
With the FCA adopting a proactive position on fund governance – as evidenced by its Asset Management Market Study’s (AMMS) focus on value for money and the introduction of the Senior Managers & Certification Regime (SMCR) – independent depositaries are likely to play an ever-expanding role in supporting best practices across the buy-side, in areas such as corporate governance.
INDOS also anticipates private equity and real estate asset classes, where corporate governance standards have fallen slightly behind hedge funds and traditional long only firms over the last few years, will make significant improvements to their oversight processes. INDOS is seeing and hearing evidence of a shift towards the use of independent depositaries in the private equity and real estate market.
Brexit and Depositaries
While the UK may be departing from the Single Market, the country is unlikely to expunge the basic AIFMD principles including depositary for local asset managers. Regulatory equivalence with the EU is much sought after inside the UK, and jettisoning the need for managers to appoint a depositary would diverge from achieving that objective.
Admittedly, the likelihood of a cliff-edge Brexit has receded in recent months, but UK depositaries should still be identifying ways and means by which to continue supporting EU clients. Under AIFMD and UCITS V, depositaries must be located in the same jurisdiction as the EU funds they are servicing. Most UK depositaries will have branches or subsidiaries distributed across the EU, but Brexit will force these providers to reorganise themselves if they want to retain EU clients.
Technology and Depositaries
Blockchain’s applicability in the depositary world is still not clear, although the technology is being evaluated across a number of INDOS’ counterparties and partners including prime brokers, custodians and fund administrators. At the most incremental level, depositaries may over time start to receive data from counterparties using Blockchain technology, something which will expedite cumbersome reporting processes and help eliminate mistakes.
Equally, depositaries could play a significant role in validating data on underlying assets and cash-flows reported onto a Blockchain by managers and their providers, adopting a governance role similar to that envisaged by market infrastructures in the securities services industry. Nonetheless, INDOS believes that further standardisation of Blockchain processes is required, an objective which is likely to take several years to achieve.
INDOS, however, sees enormous potential in artificial intelligence (AI) tools and is developing its proprietary DEPOcheck technology to employ AI to spot erroneous data sets or trends. By using AI software in an oversight capacity, depositaries will be able to spot and report errors more quickly and accurately, helping to strengthen investor protections and bolster confidence in the asset management industry.