After the Dust Has Settled

10 predictions for the depositary market in 2015

Originally published in the January 2015 issue

INDOS Financial Limited, the UK independent AIFMD depositary, sets out its predictions for developments that will impact the depositary market for alternative investment funds in 2015.

1. Depositary performance reviews by managers leading to provider change
We expect to see some managers change providers (particularly from Q2 2015 onwards) looking to improve the service quality and value they obtain from their depositary.
Many managers acknowledge that, faced with the overall challenge of becoming compliant with AIFMD in 2014, they appointed an affiliate of their fund administrator as their depositary since it was the easy route to take, and planned to revisit their options and decisions at a later date. Towards the end of 2014 we started to hear from some managers questioning this decision, citing lack of transparency, poor client service and off-market commercial terms.

2. Increasing focus and investor awareness about the role of the depositary
We expect increased due dilligence on depositaries.
The depositary was an entirely new service provider for offshore, non-EU funds. Investors are asking more questions about the role of the depositary and the reasons behind decisions to appoint firms. In common with the increasing amount of due diligence being undertaken by investors on fund administrators, we expect this due diligence to extend to depositaries. We will start to see more depositaries undertake external control audits to provide managers and investors assurance.

3. Increasing focus on conflicts of interest
We expect investors and managers to focus more on the potential conflicts of interest between depositaries and other service providers.
Very few depositaries are willing to act unless an affiliated entity is the fund administrator. This presents a conflict of interest, particularly in the area of oversight over the NAV calculation of the fund. Depositaries will be asked to demonstrate how they manage this conflict to ensure that the interests of the fund and its investors take priority over the interests of the depositary and affiliates within the same group.

The small number of administrators that will only allow affiliated depositaries to act will come under increasing pressure and scrutiny to justify this off-market and anti-competitive position. Regulators have also shown they are also focused on conflicts of interest (in, for example, the recent ESMA consultation on situations where a UCITS management company and the fund depositary are under common control or management) and we expect this to continue.

4. Ongoing regulatory focus on role and regulation of the depositary
We expect to see ongoing regulatory focus on the role of the depositary and potentially thematic reviews over depositaries by regulators.
It is clear that the rule-makers in Europe see the depositary as a key service provider to oversee fund activities for the protection of investors. Regulators will be keen to ensure that depositaries are operating to a high and consistent standard. The manager depositary due diligence and selection process would also likely form part of any FCA AIFMD thematic review.

5. Ongoing depositary engagement by funds moving away from reverse solicitation
We expect regulatory focus on marketing practices to increase in the post-AIFMD world and that managers with European investors in their funds will find it increasingly difficult to rely on reverse solicitation.
European managers will continue to appoint depositaries to meet the requirements of Article 36 of the AIFMD. Some US and other non-EU managers, many of whom have initially relied on reverse solicitation and “stayed away” from Europe, will revisit their decision, and we will see a growth in the number of these firms registering to market in Europe. Recent announcements from a number of EU countries to not require Annex IV regulatory reporting at the Master Fund level could also reduce the burden of marketing in Europe. Non-EU managers marketing to certain EU countries, including Germany and Denmark, are required to comply with the Article 36 depositary-lite regime.

6. ESMA to conclude asset segregation review
We expect prime brokers will be required to segregate assets between AIF and non-AIF assets.
Article 90 of the AIFMD imposes asset segregation obligations on depositaries and any appointed sub-custodian. Most prime brokerage models entail pooling of client assets in omnibus account structures. ESMA has been reviewing whether this is acceptable under AIFMD or whether prime brokers should be required to segregate AIF assets. Segregation would have a significant impact on the prime broker industry and reports suggest it could take time for prime brokers to amend their systems, and at significant cost. It is unclear whether a transitional period will be granted.

7. ESMA to issue opinion on extension of AIFMD passport to non-EEA funds and managers
We expect ESMA will issue its opinion to the European Commission on the possible extension of the AIFMD passport to non-EU funds and managers by 22 July 2015, but it is unlikely the passport will be introduced until Q1 2016 at the earliest.
At present the passport is only available to EU managers of EU funds. If the passport is extended, and managers wish to avail of it as opposed to continuing to market via private placement on a country-by-country basis, managers will need to comply with the full depositary requirements, rather than the so-called depositary-lite model required under private placement. The passport could be extended as early as end Q3 2015, but Q1 2016 at the earliest is more likely. Therefore, depositary-lite will continue as the default model for offshore funds during 2015.

8. Discharge of liability
We expect the discharge of liability by many depositaries to prime brokers to continue.
Several full depositary models put in place for EU funds involve the depositary discharging its strict liability for loss of financial instruments to prime brokers. Whilst the discharge of liability by AIFMD depositaries does not appear to be on the regulatory radar at present, there are question marks over whether AIFMD will in time be aligned with UCITS V, which does not allow depositaries to discharge liability.

9. Medium-term strategic decisions will start to be made by market participants
We expect, as the prospect of the AIFMD passport nears, to see businesses position themselves to provide ongoing support to offshore funds that would need a full depositary to be passported in Europe.
This will include depositary-lites starting the process to adapt to full-scope depositaries. Some administrators that have established depositary-lite businesses will come under increasing pressure to communicate their medium-term strategy to support clients which may want to transition from depositary-lite to full depositary to avail of the passport. Recognising the growing importance of the depositary, we could see some firms make innovative strategic decisions which involve a depositary.

In the absence of a depositary passport in Europe, we are likely to see more firms establish UK FCA-regulated branches to enable them to act as full depositary in future for non-EEA funds managed by UK managers.

10. Fees for depositary services will stabilise
We expect fees for depositary services to stabilise.
Depositaries are now realising how much work is involved to deliver an AIFMD-compliant service. Many will walk away from business rather than undertake at a loss or for no realistic risk premium. Managers and investors will increasingly see the value they can take from the service. These factors will have a combined effect of firming fees.