The future for depositaries: Brexit, conflicts of interest and the drive for added value

The role of the depositary was introduced under the AIFMD to address failings of the alternative fund management industry. AIFMD sought to help restore confidence among investors and regulators in the alternatives sector.

The depositary, alongside the fund auditor and directors, is now viewed as an important part of the governance structure that provides independent assurance to investors, boards, managers and regulators. The responsibilities of depositaries include daily cash-flow monitoring, regular asset ownership verification and oversight of fund valuations, shareholder dealing and compliance with fund offering terms.

Unlike the annual fund audit, the depositary’s oversight is on-going throughout the year and includes a review of every monthly NAV. However, the UK decision to leave the European Union in 2016 has created uncertainty about the future role of the depositary for UK managers.

The UK is expected to leave the EU in March 2019 but is pushing to introduce a transition period of two years or more. After Brexit, there have been calls in the industry for the UK government to replace AIFMD and other funds regulation with looser, less prescriptive rules.

This year’s FCA asset management market study is a good indicator this will not happen. Its focus was on strengthening fund governance to ensure the UK asset management industry is a more attractive place for investors and to improve the competitiveness of the UK market.

The depositary is viewed by the regulator as one of the cornerstones of good fund governance and will therefore likely be retained post Brexit. Retention of the depositary requirements would also be required to ensure equivalence with the EU, which would be a basic condition for continued access to European investors.

Shortcomings in the implementation of the depositary requirements could however lead to more regulatory focus on improving standards and consistency. One area of focus would be to address conflicts of interest in the depositary industry.

Frequently, depositaries affiliated to the fund administrator are appointed by managers as part of a bundled service offering, which can also extend to custody or prime brokerage. There are inherent conflicts in a model whereby one part of a business oversees and ‘marks the homework’ of another division within the same group.

Largely driven by regulatory requirements, depositary businesses are established as separate legal entities within the group. However, despite this legal separation there cannot be complete assurances that a depositary would self-report issues identified within its administrator or custody arm as this could result in financial or reputational harm at the broader group level.

A second area of focus surrounds consistency and quality of service to ensure all depositaries undertake the required duties to a high standard. A growing number of managers are reporting that engagement by their depositaries has been lacking, while others acknowledge rudimentary errors have been missed by providers. Such deficiencies are prompting searching questions about the added value of certain providers of depositary services.

This inaction has prompted several large fund managers to switch from an affiliated depositary model to an independent provider. It is not just the managers who are growing frustrated, but institutional investors, consultants and fund directors are starting to act.

Operational due diligence teams are recognising the benefits of a well implemented depositary model and are increasingly asking questions about how it functions. ‘Tick the box’ depositary models that add no value could contribute to a vetoed investment. Fund directors are also the driving force behind some of the decisions to switch providers.

A properly functioning depositary that can and will challenge the process will enhance the governance of the fund, providing increased confidence to investors, fund directors, and regulators. A focus on management of conflicts and raising the bar of expected performance will result in the UK depositary continuing to play an important role in the success of the UK funds industry in the post-Brexit era.

This INDOS Financial article was first published by HFM Week and can be read here.