AIFMD and the expected changes to UCITS have driven many fund administrators and custodians into paroxysms of anguish as they contemplate a world of unlimited liability. The concept is quite simple. If a fund loses any asset, then the agent replaces it. This is a panacea for regulators who have transferred risk to a deep pocket, and it has created panic among agents who wonder how to tackle the issue.
Rational thought should drive us to two conclusions. First, the approach of the regulators is fundamentally flawed, and second, the risk transfer has to lead to changes in the industrys business model.The risk that agents are asked to carry is primarily sub-custodian, CSD, CCP and notary/registrar risk.
There is logic in attributing sub-custodian risk to the agent, as they have choice in their appointment. Where they do not, they can seek counterindemnities from their clients as long as they deem them good for the liability assumed. The problem of funds appointing downstream agents is less common in the traditional space but will become a critical issue for hedge funds given the role of their prime brokers.If the agent is guaranteeing the assets of a fund, there is going to be less appetite for emerging or frontier markets with unclear legal structures, less robust banking systems and little tradition of fiduciary responsibility. The agent has three choices. They may take the risk on their books;they may take the risk but require a counterindemnity from the fund; or they can decline to be involved in such investment. For these strategies to work, they need to be happy that the financial strength of their client supports the worst-case scenario where they have counterindemnities, or that the fund would be able to find a successor agent, if they wish to resign, should their view of the markets covered or the creditworthiness of the client change. In practice, the regulatory changes are likely to reduce investor choice as they disadvantage small investment management companies and will limit appetite for emerging and frontier market funds.
There is though no logic in requiring agents or funds to guarantee parts of the infrastructure whose use is mandatory. That is part of investor or country risk. In the brave new world post EMIR and Dodd-Frank, funds will be pretty well compelled to use CCPs. And any failure of a CCP would have to be made good, under the intended regulations, by the agent. At least they have the option of insisting on choice of CCP and, in extremes, requiring the fund to move from centrally cleared to bilateral transactions. On the CSD side, there is usually no choice as most countries require mandatory usage of a single CSD. Nor is there choice of stock transfer agent as they are appointed by the company selected for investment. As regulators claim that these three areas are not material areas of risk, it begs the question of why they then need to be included. It also shows lack of attention being paid to private-sector concerns on the issue of lender of last resort for CCPs, liability assumption in structures such as T2S and experience of registers being rewritten in the past.
Perhaps the intended consequence of the new regulations is a desire to see fund industry consolidation.The question then is how long it will take regulators to look to unbundle such a trend as the surviving groups, with those new large contingent liabilities hit the to-big-to-fail hurdle.