AIFMD Depositary: Developing an Operating Model

August 15th, 2014
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This whitepaper is co-authored by Shane Brett, Managing Director at Global Perspectives, an Asset Management and Hedge Fund consultancy and Alan Meaney, Director at Fund Recs, a specialist software provider to the Funds Industry.

During the past six months Shane and Alan have held discussions with 30+ depositary firms around their plans for implementing AIFMD and how their framework for day to day activities might look.

This document covers AIFMD from the perspective of a depositary and discusses some of the practicalities in setting up an operating model in order to comply with the directive on a day to day basis.

The information contained in this whitepaper is general in nature and should not be taken as specific guidance for setting up an operating model.

AIFMD requires the depositary to take on strict liability for loss of assets held in custody and even if this responsibility is discharged there is still substantial risk to the depositary.

Therefore, it is imperative that any firm looking for guidance on this matter seeks advice from their local legal counsel when finalising their model.

The aim of this document is to provide a useful starting point to generate some of the internal debate and questions when transitioning from discussing the Directive to implementing processes and procedures around its compliance.

This is intended to be a working document and we plan to update it as new information on depositary operating models becomes available.

We hope you find this document useful and appreciate any feedback you might have.

Depositary Lite vs Full Depositary

The role of the depositary breaks down into three areas defined under Article 21(7), (8), and (9) of the Directive; the safekeeping of assets held in custody; monitoring of cash flows and an oversight role.

Full Depositary

Only EU AIFM managing EU AIF’s are subject to the full depositary regime (Article 21), whereby a single depositary is required to perform the three core depositary duties of safe keeping of assets, cash flow monitoring and oversight.

Under this model, the depositary is required to take on strict liability for loss of financial instruments.

However, a depositary may delegate the safekeeping of assets to sub-custodians, but may not delegate the cash monitoring or oversight duties.

Depositary lite

“Depositary lite” is the term used to describe the obligations of a depositary appointed to a non-EU AIF managed by an EU AIFM which markets in Europe under a private placement regime under Article 36 of the Directive.

The obligations of a depositary lite are similar to those applied to a full depositary with a few key differences.

The liability standard for the loss of the AIF’s assets in custody is negligence rather than the strict liability standard.

It is possible for different entities to undertake the different depositary lite tasks; therefore, a prime broker could be responsible for safekeeping (assuming it had segregated the depositary function from the prime broker one), an administrator for cash monitoring and a supervising entity for oversight.

Strict liability

Under AIFMD the depositary remains liable for the loss of any of the AIF’s assets held in custody unless it can prove that the loss has arisen as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary.

This effectively makes the depositary strictly liable for the loss of assets in custody, which is a significantly higher standard than the one depositary firms are used to.

The pre-AIFMD standard of liability contractually assumed by depositaries did not extend to loss of assets by their agents or sub-custodians, except where they breached their legal standard of care in the selection, appointment and monitoring of such agents or sub-custodians.

This contrasts to the AIFMD position where, in the absence of force majeure events, a discharge of liability, or a safe harbour for assets held through a central securities depositary, a depositary is strictly liable for loss of assets in custody by any party beneath them in the chain of custody. This includes all sub-custodial agents and prime brokers (and their own independent sub-custody networks).

Depositary Functions

Under AIFMD the depositary has three key functions which must be executed. These are the:-
• Safekeeping of Assets
• Oversight of the Fund
• Cash Flow Monitoring

We will look at each of these requirements in turn, as well as identifying some of the key considerations for depositaries in developing their operational model.

Safekeeping of Assets

Requirements under AIFMD:-
• Under the AIFMD the depositary must maintain either custody or recordkeeping for all the assets on the fund.
• The funds’ assets must be properly segregated on the depositary’s books or on the books of its delegates (e.g. sub custodians)
• The depositary is required to monitor the custody risk throughout the chain of custody on an on-going basis.
• All assets of the fund which cannot be held in custody by virtue of their nature (e.g. investments in other Collective Investment Schemes) must be recorded and monitored by the depositary.
• The assets of the fund must be separated from the assets of the depositary in such a way that they can be clearly identified as belonging to the fund at all times.

Operational Considerations

• There is still some debate regarding the level of segregation required under AIFMD. Many depositaries feel it is extremely difficult to implement the segregation requirements of AIFMD in practice. We would recommend a “best efforts” basis be put in place for all funds and their assets.
• Implementing this separation of assets is likely to increase the cost of the depositaries operational model, as they put in place the required financial, operational and technological enhancements required to comply with the segregation rules.
• It is still unclear how many national regulators view managing conflicts of interest - where the same large organisation could be providing depositary, custody and administration services (“One-Stop Shop” model) to an AIFM. Depositaries would be advised to ensure their depositary model is developed as a clearly separate function with its own processes, controls and reconciliation functions.
• Depositaries need to consider how they will best mitigate risk in their operating model if one of their prime brokers proves unable to perform the custody function on behalf of the fund (for example in the return of the funds’ assets). Enhanced and on-going prime broker monitoring and due diligence will be required.
• In completing their prime broker due diligence depositaries need to ensure they are comfortable with the operational model and controls the prime broker has in place. Where these models do not match the depositaries risk profile, the depositary may not wish to have the prime broker appointed. This could lead to a conflict with the fund manager and their investment strategy.
• Operationally depositaries need to consider carefully how prime brokers and sub-custody delegates outside the EU will be managed. Local laws (for example in the US) could be different (or even conflict) with the requirements of European regulation.

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