Developments in the Depositary-Lite Regime

The shifting regulatory perspective is becoming clearer

Originally published in the July 2013 issue

In the February 2013 edition of The Hedge Fund Journal we published “Depositary-Lite: Simple as the theory sounds?” in which we explained the so-called ‘depositary-lite’ regime of the AIFMD, and the issues which the industry could face in seeking to comply with the new requirements. Since February, there have been a number of positive developments which have been summarised below.

To recap, following the introduction of the AIFMD, UK and other EU hedge fund managers that wish to market their non-EU, offshore hedge funds to EU investors through private placement will need to comply with the depositary-lite regime. This requires one or more firms to be appointed to perform the depositary duties of safe-keeping of assets, cash-flow monitoring and oversight (principally the oversight of the valuation process, subscriptions and redemptions, compliance with laws and regulations, investment restrictions and leverage).

Many of the AIFMD requirements for depositaries go beyond the custodian/trustee requirements which apply to EU funds today. The cash-flow monitoring procedures, in particular, require a daily reconciliation and monitoring of unusual cash flows, whilst the oversight requirements are an entirely new requirement for offshore hedge funds. The good news is that the depositary-lite requirements do not apply to non-EU alternative investment fund managers (AIFMs) at all, and the strict liability for loss of assets which will apply to depositaries of EU funds, and the potential increase in costs to the funds which may result, also do not apply.

In February we noted that the UK was proposing to ‘gold plate’ the depositary-lite area of the directive by requiring, in certain situations, a single UK depositary to perform all the duties. This would most likely have resulted in additional cost to funds and a more complex implementation and ongoing operating model for existing service providers and managers alike. Much to the relief of the industry, this gold plating has now been removed in the UK’s amended AIFMD Regulations which became law on 22 July 2013. Instead, the Financial Conduct Authority (FCA) will require that any UK firm performing the duties will need to hold an ‘Article 36 Custodian’ regulatory authorisation. It is not, however, necessary for a UK firm to be appointed to perform any of the duties, but, unlike in the UK, the precise regulatory framework which will apply to firms performing these duties that are domiciled in other fund centres such as Ireland and Luxembourg remains unclear.

Given that the AIFMD, and now the UK, will allow one or more firms to perform the duties, many still believe the most efficient and lowest cost, and therefore preferred, model would be for prime brokers and custodians to continue to perform the safe-keeping duties, the fund administrator to perform the cash flow monitoring duties and a trustee/depositary business to perform the oversight duties. An alternative model may emerge whereby certain depositaries may only accept appointment where they perform all three depositary-lite duties – for risk management and other reasons, they want to operate broadly consistent processes regardless of whether they are acting for an EU or non-EU fund.

Another positive development is the transitional approach to AIFMD which some countries, such as the UK, will apply. These will allow managers to continue to market their funds until the earlier of their date of authorisation as an AIFM or July 2014, before they are required to comply in full with the new rules. Managers that plan to market through private placement will, however, need to notify the FCA of their chosen depositary-lite providers in their AIFMD ‘variation of permission’ application. We expect that the FCA will want to see that appropriately regulated firms are proposed and will independently check with those firms that they are prepared to act. We anticipate that the FCA will also focus on the suitability of non-UK firms appointed to perform the depositary-lite duties. Unfortunately, new managers that were unable to become authorised prior to 22 July, will need to launch straight into the AIFMD regime (including compliance with the depositary-lite requirements) and will not be able to make use of the transitional provisions.

The primary focus of prime brokers and depositaries remains agreement of the single depositary model for EU funds. However, we expect that UK-based prime brokers will seek to obtain the necessary Article 36 custodian authorisation in order to perform the depositary-lite safe-keeping of assets duties, and administrators are considering how to adapt their existing reconciliation procedures to comply with the cash-flow monitoring requirements. As reported in the February article, it is still widely expected that most existing trustee businesses will only be willing to perform the oversight duties where an affiliated entity already performs fund administration. Firms that are willing to perform any depositary-lite duties where an affiliate does not also perform fund administration are likely to only do so for significant accounts which could leave small to medium-sized managers – and those that need to market via private placement the most to attract and grow assets – in a difficult position.

As part of their AIFMD implementation planning, a number of managers have started to consider how they will comply with the depositary-lite requirements. Several of those managers appear to be frustrated about the lack of clarity around depositary-lite solutions (and the potential cost). In the industry’s defence, it is only recently the UK has removed its gold plating in this area and introduced the new concept of the Article 36 Custodian, and the regulatory position in other member states remains unclear. However, in common with a number of other areas of AIFMD, solutions are starting to emerge. The picture should become clearer now the 22 July deadline has passed, and depositaries and prime brokers have resolved the single depositary model for EU funds so that they can turn their attention to depositary-lite.

INDOS Financial was established in late 2012 with the sole purpose to develop a pragmatic and flexible depositary-lite oversight solution for offshore hedge funds. Unlike almost all trustee/ depositary businesses today, INDOS is 100% independent, and will work with most leading fund administrators, leaving managers free to use their existing service providers. INDOS has recently submitted an application to the FCA for authorisation as an Article 36 custodian/depositary.