Asset segregation is one of the basic tenets of AIFMD, and is aimed at improving investor protection. However, there has been considerable debate amongst the depositary and prime broker communities over the last 18 months or so regarding the precise asset segregation requirements of AIFMD.

Under AIFMD, depositaries are essentially subject to strict liability for loss of financial instruments held in custody. As prime brokers appointed by funds hold such assets, depositaries must appoint those prime brokers as their delegates. The outcome of a Consultation Paper and Guidelines on the subject of asset segregation published by ESMA on 1 December 2014 is likely to be something of a game changer in the way in which prime brokers of EU AIFs operate. The main question mark had been as to whether or not AIF client assets and non-AIF client assets were required to be segregated from one another. Prime brokers maintained that if they could not hold all client assets, whether AIF or non-AIF, in a pooled or omnibus account, they would have difficulty in re-hypothecating those assets.

ESMA has indicated that the segregation requirement in Article 99(1)(a) of the AIFMD Level 2 Regulation (Regulation 231/2013) is that, where a depositary delegates the safekeeping of assets to a third party (e.g., a prime broker or collateral manager), the third party must distinguish assets of AIF clients from (a) its own assets, (b) the assets of any other client of the third party, (c) the assets belonging to the depositary itself and (d) the assets belonging to clients of the depositary that are not AIFs. This means that the account where the AIF’s assets are to be kept at the level of the delegated third party can contain only assets of the AIF for which safekeeping has been delegated to the third party and assets of other AIFs, but not non-AIF assets.

The draft Guidelines are in response to additional questions on whether the assets that can be held in the account are only those coming from the same delegating depositary or, alternatively, whether the account can hold assets for AIF clients coming from different delegating depositaries. In the draft Guidelines, ESMA seeks views on two alternative options:

First option. The account in which the AIF’s assets are to be kept by the delegated third party (including a prime broker or collateral manager) may only comprise assets of the AIF and assets of other AIFs of the same delegating depositary; or

Second option. A delegated third party holding assets for multiple depositary clients would not be required to have separate accounts for the AIF assets of each of the delegating depositaries.

In preparing the paper, ESMA consulted with the Consultative Working Group of ESMA’s Investment Management Standing Committee on various possible approaches on asset segregation under AIFMD. ESMA rejected two other options which would have involved the commingling of AIF and non-AIF assets, either on a depositary-by-depositary basis or by commingling assets from different depositaries. However, ESMA fell short of suggesting another option, which would have required AIF assets to be segregated on an AIF-by-AIF basis at the level of the depositary’s delegate.

The deadline for responses to the consultation is 30 January 2015. ESMA intends to finalize the Guidelines and publish a final report in the second quarter of 2015. Regardless of which option is chosen, the Guidelines and proposed implementation timetable (circa mid-year 2015) are likely to be challenging for the EU prime brokerage industry. One way or another, the Guidelines will require significant changes to existing prime brokerage models and undoubtedly will attract attendant costs.