AIFMD’s Depositary Lite: Handy Option With Limited Lifespan?

It’s lite, but is it right?

That’s the question, some fund managers should be asking themselves about which business model they use when selecting a depositary to perform critical post-trade services under the new European Alternative Investment Fund Managers Directive (AIFMD), a regulatory initiative which enables cross-border marketing of alternative funds in EU countries.

Given the right circumstances, they can pick one of two alternatives: a full-fledged depositary or a depositary-lite version offered by a growing number of independent fund administrators. The lite model might cost a lot less, more than 50 percent less, some European fund managers tell FinOps Report. However, there is a catch:  fund managers don’t always have the right circumstances to have this choice. The depositary requirements they must meet depend on where they and the fund are domiciled and where they want to market.

As a result, some non-EU fund managers — particularly US ones — are postponing the decision to market alternative funds in the EU while they wait for changes in regulation, while others have decided to abandon the idea of marketing in Europe altogether. “We haven’t seen a lot of action from US asset shops who prefer to sit on the sidelines until there is a clear direction on whether European private placement rules will be continued, abolished or altered,” one partner at a UK law firm tells FinOps Report.

The Three Tasks

The AIFMD, which currently is open only to EU-domiciled fund managers, calls for hedge, private equity, and other types of alternative fund managers to select a single depositary to perform three critical tasks: safekeep their assets, monitor the cash flow in and out of their funds and perform some oversight functions — aka ensuring the net asset value is calculated correctly and that the fund is managed according to the offering documents. In return, these managers will be able to take advantage of AIFMD’s “passport” to easily market their funds across all of the EU member states with the additional provisos of more rigorous reporting and risk management.

All they have to do is win approval of one national regulatory body. Ireland and Luxembourg are the favorites, in large part because they transposed the high-level requirements of AIFMD into their local rulebooks first. They also have the most experience administering UCITS, AIFMD’s longstanding parallel regulation for the traditional fund market.

While the depositary responsibilities may sound perfectly reasonable, they come at a hefty cost for custodian banks — which would likely serve in the role of depositaries — and their fund manager clients. The reason: a full depositary must also operate under the premise of a “strict liability.” It is responsible for making the fund whole in the event an asset is lost due to fraud, embezzlement or even bankruptcy of a third-party provider. It doesn’t matter whether or not the depositary was at fault, even if a sub-provider like a subcustodian or even an international or local depositary is to blame. Such a scenario has full-service depositaries counting up the potential costs of risk. Naturally, they are charging a lot more for the services that include strict liability — costs which fund managers will likely pass along to investors.

Key Differences

Enter the depositary-lite model. It can’t be used by European fund managers with European domiciled funds who must participate in the AIFMD regime to market their funds cross border. They are tied to the full-fledge depositary model, say European legal experts. Depositary lite is only available to European managers of non-European funds and non EU-based managers who can only market their funds in Europe through National Private Placement (NPP) rules and want to market in Denmark, Austria, France or Germany. Other nations may not require the selection of either depositary model for those two types of fund managers, but will impose their own NPP rules which can still be onerous to follow.

These four countries have “gold-plated” their requirements of non-EU fund managers marketing their non-EU domiciled alternative funds to include the depositary requirement, softening it slightly to allow them “to pick more than one service provider for depositary services, which combined would conduct the three required functions,” explains Bill Prew, chief executive officer of INDOS Financial, an independent depositary-lite provider in London and the first to win approval from the Financial Conduct Authority (FCA).

Of the four countries, Germany appears to be the most popular among non EU fund managers, say European legal experts, while France might be shunned completely over concerns whether it will actually permit non EU-fund managers to do business.

But lite isn’t exactly the same as the full-fledged depositary regime. Because of the flexibility in hiring multiple providers, existing custodians or prime brokers of a fund can continue to act as custodians and satisfy the safekeeping requirements of financial instruments while a  fund administrator could provide cash flow monitoring, safekeeping of other assets and operational oversight, explains Des Pierce, head of strategic markets at SS&C GlobeOp in London. “The depositary-lite model better reflects the reality of the status quo, allowing fund managers to keep their current relationships,” he says.

Practically speaking, that means that under the depositary-lite model the custodian bank or prime broker would only be responsible for any shortcomings defined under the terms of its contract, not strict liability. It doesn’t sound like such a terrible idea. After all, it was the accepted industry practice before the AIFMD came around. But it may not be favored by institutional investors who could prefer a strict liability approach. “Many larger funds with institutional investors will insist on a full-fledged depositary model,” says David Morrissey, director of SEI Investment Global Fund Services in Dublin.

There also are some who might decide on the depositary-lite model as a temporary means of accessing some European investors before moving into a full-fledged depositary model. “It’s a happy medium particularly for those that want to market in some EU countries,” says Morrissey.

Picking and Choosing

Even so, not all depositary-lite programs are equal. Some providers will also limit just who they accept. “We are primarily working with clients who also avail themselves of our administration and middle office services,” says Pierce, whose firm offers depositary-lite serices through its regulated entity in the UK. The reason: the cash monitoring, safekeeping and oversight roles are far more complicated for some asset classes, such as over-the-counter derivatives and private equity funds than plain vanilla equity and fixed-income instruments. Therefore, an efficient exchange of information is required which SS&C GlobeOp, as a subsidiary of SS&C Technologies, says it can accomplish through its technology platform.

Regulatory oversight of depositaries also isn’t equal. The UK’s FCA requires any UK firm offering any of the three required depositary-lite duties to be regulated. Ireland’s central bank says that it will oversee only those providing safekeeping services, but not cash-flow monitoring and oversight. Wanting to play it safe, many independent Irish fund administrators have decided to establish UK-regulated depositary-lite offerings.

Restrictions aside, depositary-lite programs could end up being nothing more than a temporary fix. Come 2018, they might no longer be offered if local European private placement rules are eliminated as an option for non-EU fund managers in updates to AIFMD. Should that occur, the only way to market any fund to any European investor would be through the AIFMD “passport” and the full-fledged depositary model. “The jury is still out as to what will happen with the depositary-lite model, but for the time being it’s a very popular option,” says Pierce.

Changes in the AIFMD regime will be coming in anticipated extensions of the directive. There is talk of a limited opening the AIFMD passport program to non-EU managers sometime in 2015, which would put them in the same boat with their EU-domiciled brethren in having to meet full-blown depositary requirements . Likewise 2018 is the year that the NPP rules, including the gold-plated versions with full-blown and lite depositary models, may be steamrollered out of existence by AIFMD.

Acknowledging the potential for the future abolition of the depositary-lite model, Morrissey says his firm is still happy to be accommodating as many clients as possible, while INDOS Financial has also come up with a game plan. “We are monitoring developments with the extension of the AIFMD passport to non-EU finds and non-EU managers closely. We could decide to expand to offering a full-depositary service which would require us to capitalize the business and extend our regulatory permissions,” says Prew.