Depositaries: The new ‘must have’ relationship

Depositaries - AIFMD Insider News

The appointment of a depositary (an independent third-party) may be the single most important strategic decision that an alternative investment fund manager (AIFM) will make under the directive. Any AIFM seeking to market in Europe should be making it a priority to select a depositary.

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If one thing is clear from the AIFMD, it’s that the relationship between AIFMs and depositaries is about to fundamentally change. In fact, we believe that the appointment of a depositary may prove to be one of the most important decisions that an AIFM makes under the new regulatory regime.

The story so far

According to the AIFMD, fund managers are required to appoint an independent third-party depositary for each of their funds. Under the new rules, the depositary fulfils three primary functions (PDF 80KB) on behalf of the AIFM: cash flow monitoring; the safekeeping and recordkeeping of assets; and the oversight of certain operational AIFM functions.

To drive home the gravity of the role, the directive asks depositaries to take on greater responsibility for the funds they are servicing. This essentially makes them liable for loss of assets at any point in the chain of custody, as well as for pricing errors which have occurred in the alternative investment funds (AIFs). So as not to be liable for such errors, the depositary has to prove that it has sufficient processes and procedures in place. It needs escalation plans so that identified errors are either addressed with the AIFM or, where necessary, reported to the regulators. 

A complicated relationship

Unsurprisingly, the proposed rules bring a whole new level of complexity to the relationship between depositaries and AIFMs. With depositaries now thrust into the role of sheriff and overseer, certain factors assume greater importance such as trust, adequate risk management and transparency. We’ve already seen many instances where – as a means to manage risk and limit the number of prime brokers they work with - depositaries have ended relationships with AIFMs. To hang on to their depositary, AIFMs must show a willingness to share key data with them.

We firmly believe that AIFMs who have not yet locked a depositary in for each of their AIFs should make this a top priority. The reality is that the list of depositaries that are ready, willing and able to not only deliver these services but also satisfy the stringent liability requirements is not a long one. A number of depositaries are already rumored to have ceased accepting new clients during this time of learning, so as to help mitigate their overall risk during the transition period.

Clarity coming

Fortunately, we expect regulators and industry associations to start providing much-needed guidance to depositaries. Hopes are high that this will reduce some of the complexity, bring greater consistency between member states and clarify new responsibilities. Some issues, such as the need for depositaries to perform due diligence on the AIFM’s transfer agents (who, theoretically, may serve as custodians), should be fairly easy for national regulators to clarify and simplify on their own.

Other issues – particularly the requirement for depositaries to ensure that all assets belonging to the AIF are properly segregated throughout the entire custody chain – seem very complicated to implement in their current form and will likely need more work at the commission level before their impact and implications can be fully understood.

Depo Lite

While this may – on the surface – seem like unfortunate news, there may be a silver lining in the regulation for some. EU AIFMs managing non-EU AIFs marketed in the EU can operate a Depo Lite service. These services can be offered by fund administrators, with the provision that they are appropriately regulated or supervised. Depo Lite providers will still need to carry out all three required functions. However, thanks to a lighter liability requirement and the fact they do not necessarily need to be a credit institution, this could result in a lower fee structure.

An immediate priority

For depositaries and AIFMs operating in the EU, the top priority is simple: build a strong, trusting and transparent relationship with your chosen depositary and start working together to define the contractual particulars and create appropriate operating models that allow each party to fulfill their respective role under AIFMD.

Given the global reach of AIFMD and the often limited knowledge of EU regulation demonstrated by many non-EU AIFMs, we would suggest that non-EU AIFMs seeking to market AIFs in Europe should first talk to their European counterparts and advisors about their depositary requirements - especially as some Private Placement Regimes in EU Member States have changed and also require a depositary for these managers. The bottom line is that there is a significant difference in approach between the EU and other jurisdictions; non-EU AIFMs should be diligent.

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