I have recently been involved in a series of discussions on the liability structure of the market post the Alternative Investment Fund Managers Directive (AIFMD) and also post the upcoming UCITS V regulations. It is obvious to all that the intermediary sector formally assumes more risk than before as a result of these changes. Some argue that they always had equivalent moral obligations, if not legal, before AIFMD. Clearly now those obligations are enshrined in regulation and thus law. Some argue that the changed regulatory environment has burdened them with close to unacceptable levels of liability. The majority appear to be willing to accept this new potential cost of doing business.
In some ways, the reality of the change in industry risk profiles has been muted by the sanguine approach to this new structure by regulators. There is discussion of potential capital impacts of some traditionally zero cost-based risks post-Basel III, with intraday liquidity, indemnified stock lending and tri-party style repos being the most celebrated. But there has been no indication that the increased, or more formalized, risk environment requires more operational risk based capital support. As most operational risk models are based on historic loss experiences and the regulations are too recent to have spawned actual financial losses, this is no surprise. But it is creating a false sense of security.
I struggle with three core challenges for the industry. The first is its technical competence. The second is the role of intermediaries in investment decisions. And the third is the eventual interpretation of those high “standards of care” and issues “beyond the control” of intermediaries.
The role of the administrator and custodian changes with the new regulations. Over and above their general obligation of oversight of funds, they have an obligation to monitor cash flows, assess the credit worthiness of their custodians, be more closely involved in fund pricing and ensure the legal segregation of their assets from the property of their custodian. They are thus cash manager, credit analyst, valuation expert and lawyer on a global basis. Obviously these skill sets exist in all the major banking institutions. And most major players have mobilized the appropriate resources on the legal and credit front. Paradoxically, the major Achilles Heel may well prove to be cash management, for custodians are often not skilled payment or cash operations experts and, despite the organizational unity of that skill set with securities services under most banks’ Global Transaction Banking umbrellas, there is less interaction than I would expect between the two. A second Achilles Heel is in the pricing and valuation fields. The bulk of pricing is for exchange-traded securities where there are multiple reliable sources of information. But a substantial proportion of assets are in complex instruments or unlisted assets and, although many of the large firms have skilled technicians focusing in this area, that is not the case for all. And I have to admit being most nervous when I see the structure of several of the non-bank administrators in this area.
Intermediaries are also being forced into investment decision-making. Although there is a technical structure available under the new regulations to eliminate country specific risks, I suspect that few will actually deploy it. The reality is that custodians and their sub agents now need to assess markets at two levels. There are markets that are valid for all investors and markets that are for all bar funds operating under AIFMD and UCITS V. There is definitely reticence in identifying excluded markets and, personally, I believe it is wrong that such an investment decision, tantamount to country risk analysis, is placed on intermediaries. Country selection, like stock or instrument selection, if within the Articles of the relevant fund, should be the exclusive role of the investment manager. And again, I see little sign of intermediaries barring markets. But there are markets where central securities depositories (CSDs) and other parts of the mandatory infrastructure take little or no liability for hacking into their environment or staff fraud or malpractices. And there are markets where the concept of beneficial ownership is not recognized in law. Should these be acceptable for alternative or other mutual funds? Again, there has never been a loss in this area and so there is no panic. But, given the scale of investment in even some smaller markets (and some with the negative features I mention are far from small), the headline risks, which I define as maximum loss possible, could be P&L painful even for the largest banks.
And I still struggle with some of the general wording of many of the regulations. I have a horrible suspicion that the eventual interpretation of the high duty of care will equate to the legal interpretation of “best endeavors.” It will not be interpreted as acting in line with professional standards (and it would be useful for one of the industry associations to propose some). It risks being interpreted as a care that would have identified the risk causing the problem, irrespective of the nature of that risk. After all, bankers have been castigated for failures over the past years, some of which were due to their rank stupidity, some to greed and some to the simple fact that they were unforeseeable circumstances. But all are treated in like fashion and no differentiation is allowed between the different causes in either the court of public opinion or the regulatory tribunals.
And what is really beyond one’s control? Substantial analysis is undertaken of infrastructures by a very skilled group of network managers, supported by independent analysis of all aspects of those entities. But, as we experienced with the fall from grace of many triple A rated investment instruments or credit institutions, the decline from low risk to non-investment grade can be rapid and unexpected. If the unexpected happens and no preventative action has been taken or no advance warning has been given, what will the judgement be? The logic supports the case for the defense where events have been rapid and unexpected. The danger is that the reality may be very different.
I disagree with those who say things have not changed substantially. And I believe we need to be vigilant about our client bases, disciplined about the fund structures we are willing to onboard, careful that we have the right skillsets available and, above all, seek that dialogue with the authorities to ensure a clear understanding of our obligations. For if we are underplaying our risk profiles, we will not adopt the right level of operational due diligence and, above all, we will tolerate the wrong price for our products.