Reacting to Developments in Regulation

Charting a smooth course through AIFMD implementation

Originally published in the August 2013 issue

Designed to establish a harmonised regime across the EU for various forms of alternative investment fund (AIF) management, including hedge funds, funds of funds and private equity, the Alternative Investment Fund Managers Directive (AIFMD) is scheduled to come into effect on 22 July 2013. AIFMD will certainly impact responsibilities, liabilities and risk for EU AIF managers and their prime brokers, depositaries, administrators, and custodians.

AIF managers in the EU must therefore ensure they have a good understanding of the short and long-term effects of the Directive on their business and plan accordingly. They will need to appoint a depositary and make the changes needed to their systems to meet the reporting requirements of the Directive.


A subtle shift of power
AIFMD brings AIFs under an unprecedented degree of regulatory scrutiny.

One of the key requirements is that all AIF managers must appoint a depositary to be responsible for three things:

  • Safe-keeping ofassets (or, in the case of non-clearing assets, asset verification);
  • Monitoring the cash movements between the AIF manager, its underlying funds and all of its counterparties; and
  • Providing general oversight of the fund’s investment activities to ensure they adhere to its governing documents.

These provisions significantly increase the breadth and importance of the depositary’s role – a higher-profile role that comes at a cost for depositaries since their work load, tracking, monitoring and risk increases accordingly. Indeed, a key point of AIFMD is the strict liability provisions that apply to the depositary of a European AIF. The depositary for a European AIF will be held liable for the loss of any financial instruments that they directly hold in custody on behalf of the AIF. It will also be held liable for the loss of financial instruments that are held in sub-custody accounts with a third party. Typically, the depositary will treat the AIF’s prime broker as a sub-custodian but the depositary retains the liability. Although the fund manager continues to be responsible for appointing its own prime broker and fund administrator, the depositary’s oversight role – and the liability it assumes as a result – means that it is likely to want to exercise influence over those decisions. Certainly, the depositary will want to carefully consider operating models to ensure it has the control it needs and reassurance that the assets are properly segregated from non-AIF assets. In simple terms, depositaries are going to want to work with prime brokers, fund administrators and custodians that they know, trust and who have a solid financial backing.

With the implementation of AIFMD imminent, fund managers should be engaging with depositaries now. While there are about 10,000 alternative funds being managed in the EU today; there are only 28 depositaries. Since there is a practical limit to the number of funds that can be taken on in a relatively short period of time, managers should address their depositary needs with a real sense of urgency.

A practical look the depositary’s expanded role means
The obvious impact is that depositaries, for the first time, will be underwriting potentially huge levels of risk – substantially more than under the current regulatory regime. As they will be required to delegate sub-custody to prime brokers (for which they still retain liability), there will be increased scrutiny on the operational effectiveness of both the prime broker and the prime broker’s sub-custodian network. As a result, it’s feasible that liability concerns may lead some to withdraw from certain geographical markets and/or asset classes. Only depositaries with sufficient size, geographic reach and capital will be able to make the necessary provision for their potential liabilities. Together, these factors are expected to fuel significant industry consolidation – an unintended, and perhaps undesirable, consequence of the Directive.

Those that remain will have to adapt to the operational demands integral to this more central role in the value chain. Almost all depositaries will need to upgrade – to varying degrees – their existing capabilities. As depositaries prepare to become responsible for the restitution of financial instruments in the event of a loss, such enhancements will need to focus on three key areas.

  1. Due diligence: since depositaries must ensure that sub-custodians (which, because of the existing model in which prime brokers hold the fund’s assets and use them for rehypothecation, might well be prime brokers and their sub-custodians) are “fit for purpose”, regular market-level due diligence will be required with the depositary reserving the right to demand a change if the custody risk is deemed too high with a market or a sub-agent.
  2. Cash monitoring: the ability to monitor all cash movements of AIF assets will be essential. Being able to accurately track and break down the movement of trillions of dollars of client monies potentially across thousands of bank accounts globally and pinpoint their precise position at any given time will require superior overview positions powered by heavyweight technological capabilities.
  3. Liability: finally, depositaries may also want to offset liability – for example, by acquiring indemnifications from delegated parties (i.e., sub-custodians or prime brokers). The industry’s model for doing this has yet to be decided – and once again, active and ongoing market dialogue is vital.

An integrated model
While the ideal model for AIFs might have to be developed individually with all parts of the chain, an integrated model – in which, depositary services, administration, cash management, corporate administration, sub-custody and potentially one of the prime brokers (in a multi-prime broker model) is provided by the same organisation – has several important advantages, not least that it leverages the efficiencies and cost-savings inherent in a larger, global provider’s domestic network and capabilities.

Models that split depositary and administration services will most likely result in higher costs. This is due to the replication of the processes, procedures and systems infrastructure required to ensure that AIFMD rules around cash management and asset safe-keeping are met. Since this extra layer will no doubt be priced into the cost of services rendered, the AIF manager could effectively pay twice to have similar processes performed. The depositary has to have its own complete records and therefore has an obligation to build the records based on its own policies and procedures. There is inherent inefficiency in splitting the roles.

An integrated model, meanwhile, can avoid such duplication and offer cost benefits while more effectively mitigating risks (by allowing the provider to retain tight control of the assets). This increases visibility – keeping everything in line-of-sight through internal systems and controls. In addition to being more secure, this reduces the administrative burden, and – through greater transparency – aids compliance.

Time for action
As AIFMD’s July implementation date nears, one thing is clear: AIF managers must be aware of the urgency of preparing for the Directive’s implementation and discuss their individual needs with their depositaries immediately. An integrated model – one that mitigates risk, reduces costs, and maximises the advantages of these changes – will often be the best way of doing so.


European Parliament votes to remove 1:1 remuneration cap and performance fee restrictions on UCITS
On 3 July, in a vote on the updated Undertakings for Collective Investment in Transferable Securities Directive (UCITS V), the European Parliament removed proposals for a cap on variable remuneration and restrictions on performance fees.

This reverses the position adopted on 21 March by the European Parliament’s Economic and Monetary Affairs (ECON) Committee, which proposed a 1:1 cap on variable remuneration in relation to fixed remuneration and placed restrictions on performance fees. UCITS fund managers will now only be subject to restrictions on the cash element of bonuses and rules on claw-backs and deferrals as proposed by the EU Commission.

The final position on the revised UCITS V Directive will be subject to negotiation between the Council and Parliament, once the Council adopts its own amendments to the Commission proposal. It is not clear when Member States will adopt a position of their own on the Directive.

EU Finance Ministers reach compromise on rules governing trading and investor protection (MiFID 2)
On 21 June, the EU finance ministers agreed a compromise position on the Markets in Financial Instruments Directive (MiFID 2) which needs next to be discussed with the European Parliament and EU Commission.

The proposal places stringent restrictions on dark trading taking place in equity markets and opens the possibility for venues and central counterparties (CCPs) to be required to allow access to alternative providers, though only in certain circumstances.

Further negotiations on EU level will focus on key political issues including: transparency in the equity markets, algorithmic/high-frequency trading (including whether to require minimum order resting times), restrictions on OTC trading, access between venues and CCPs, investor protection issues (such as the obligations placed on investment advisors) and access to EU markets by non-EU firms providing MiFID services. The implementation is set to be two years after the proposal is finalised, but this may be subject to further discussion.

New EU regulation on credit rating agencies enters into force
On 20 June, the new EU regulatory package on credit rating agencies (CRAs) entered into force. The new rules aim to reduce over-reliance on external credit ratings and promote competition between CRAs. The credit agencies are required to be more accountable for their ratings and more transparent when rating sovereign states. New rules require CRAs that have entered into a contract to issue credit ratings on re-securitizations cannot also issue credit ratings on new re-securitizations with underlying assets from the same originator for a period exceeding four years. At least two CRAs should be engaged to provide independent credit rating of structured finance instrument. The legislation requires enhanced public disclosure of information on the credit quality and performance of the individual underlying assets.

EU agrees an update to the EU Market Abuse Directive
On 26 June, the European Council approved a preliminary agreement with the European Parliament regarding the regulation updating the 2003 Market Abuse Directive.  The scope of the rules has been broadened to include financial instruments traded on all venues, OTC-traded financial instruments and the manipulation of benchmarks. The rules are also strengthened to ensure market abuse cannot take place across commodities and their related derivatives. Competent authorities are given significant additional powers to pursue perpetrators of market abuse and the sanctions regime is strengthened to ensure it acts as an effective deterrent.

Negotiations on the accompanying criminal sanctions Directive, which had been frozen pending agreement on the regulation, will now recommence. Implementation of the updated directive and regulation is likely to take place towards the end of 2015.

SEC publishes Money Market Fund (MMF) reform proposals
On 5 June the US Securities and Exchange Commission (SEC) unanimously approved proposed rules to reform MMF regulation. The SEC’s proposal outlines two alternatives that could be adopted separately or combined into a single reform package. The first alternative would require institutional prime funds – which invest in short-term corporate debt – to use a floating or variable net asset value (NAV). Retail MMFs, defined as those with $1 million-per-day redemption limits, would be exempt.
The second proposal requires non-government MMFs to impose a 2% liquidity fee if weekly liquid assets fall below 15% of total assets, and would allow the fund’s board to temporarily suspend redemptions for up to 30 days. The SEC also recommends other reforms including diversification requirements, disclosure requirements, stress testing and reporting. The comment period ends 17 September 2013.

US Derivatives Reform
In June, the US Commodity Futures Trading Commission (CFTC) granted various forms of relief from derivatives requirements under Dodd-Frank. On 3 June, the CFTC extended the time to comply with certain pre-trade screening requirements for bunched orders for futures, in order to provide additional time for market participants to coordinate on the communication of limits. On 4 June, the CFTC granted relief from central clearing for swaps entered into by eligible treasury affiliates on behalf of non-financial affiliates, subject to certain conditions and requirements. To qualify for relief, the swap activity must meet several conditions, including that the eligible treasury affiliate enter into the swaps for the sole purpose of hedging or mitigating the commercial risk of one or more non-financial affiliates. In addition, certain information must be reported to a registered swap data repository (SDR).

The CFTC also issued no-action relief to provide for transition to SEF registration, allowing swap trading facilities that were unregulated prior to Dodd-Frank to continue operating during the pendency of, and transition to compliance with, the swap execution facility (SEF) final rules.

Throughout the month several CFTC commissioners made public statements regarding the upcoming July 12 expiration of the cross-border relief from various Dodd-Frank requirements, and significant uncertainty remains given the lack of consensus within the CFTC. Of note, CFTC Commissioner O’Malia issued a statement advocating for extension of 12 July cross-border relief until 31 December 2013, and Commissioner Wetjen said in a speech that the CFTC should adopt interim final cross-border guidance prior to the 12 July deadline when the CFTC’s regulatory relief is set to expire.

CFTC Chairman Gensler has, however, expressed his intention to finalise the guidance shortly and not extend the cross-border relief beyond the 12 July deadline. On 14 June, the European Commission and ESMA announced that it would apply to the CFTC for a substituted compliance assessment to be undertaken on EU rules in respect of the CFTC’s entity-level and transaction-level requirements.