The strict liability provisions imposed on depositary banks as mandated under the Alternative Investment Fund Managers Directive (AIFMD) and UCITS V is forcing custodian banks to undertake more thorough risk assessments on new markets.
AIFMD subjects depositary banks, usually global custodians, to strict liability for any lost financial instruments held in sub-custody. However, a number of depositaries have negotiated contractual discharges of liability or indemnifications against such losses at their sub-custodians. Nonetheless, UCITS V explicitly prohibits any discharge of liability by depositary banks to sub-custodians including market infrastructures such as Central Securities Depositories (CSDs).
“The regulations, such as UCITS V, have certainly required depositary banks to conduct more thorough operational due diligence and legal assessments on sub-custodians outside of the EU. Network managers select providers which can demonstrate strong balance sheet strength, and a solid reputation. Furthermore, it is crucial depositaries ensure sub-custodians have asset segregation provisions in place, and this is recognized legally in the jurisdiction in which it is located. A number of global custodians are conducting more analysis on new markets, as these tend to be exotic jurisdictions. If there is a new market opening, our network managers are having to do huge amounts of work checking that service providers are creditworthy and that they adhere to best practices in terms of holding client assets safely and correctly,” said Mathilde Guérin, head of network management at Societe Generale Securities Services.
Others recognize some markets require attention and greater focus. “While these regulations (AIFMD and UCITS V) are two very important regulations, the impact on our network management and market intelligence function has not been significant purely because we were already adhering to many of the requirements of the AIFMD and UCITS V. It is therefore more a case of adjustment and working even more closely with our clients on markets that have a high risk profile,” said Philippe Castelanelli, global head of network management and market intelligence at HSBC.
The increased liability and responsibilities has forced some depositary banks to renegotiate fees with some UCITS funds. Nonetheless, there is speculation that there could be further alignment between UCITS V and AIFMD, and some hypothesize that the prohibition on discharge of liability under UCITS V could be extended to retail-orientated AIFMs. This would certainly lead to increased costs for those managers and their investors. This is especially true as many depositary banks to AIFMs are charging low digit basis points, which some believe is a significant under-pricing of risk.
However, fears that UCITS V and AIFMD would result in asset managers scaling back their exposures to exotic markets does not appear to have materialized.
Custodians forced to up new market risk assessments
The strict liability provisions imposed on depositary banks as mandated under the Alternative Investment Fund Managers Directive (AIFMD) and UCITS V is forcing custodian banks to undertake more thorough risk assessments on new markets.
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