Navigating Hard Brexit: The continued importance of the depositary
The UK government has finally revealed its Brexit position. Any chance of a soft Brexit or retained membership of the Single Market has apparently been removed. The UK will almost certainly pull out of the Single Market although some hope policymakers will negotiate a transitional arrangement to avoid a cliff-edge Brexit.
The risk of a cliff-edge Brexit – that is an abrupt UK departure from the EU with no interim set-up – is something service providers and fund managers need to be awake to. Nonetheless, a cliff-edge Brexit scenario would have systemic implications for the broader EU and many countries will try to avoid such a shock to their financial services industry.
Legislation aimed at UK fund managers such as the Alternative Investment Fund Managers Directive (AIFMD) and UCITS could cease to apply for UK managers in this scenario although they may remain on the UK statute books. UK fund managers look set to lose their AIFM or UCITS designation under Hard Brexit and may be unable to manage funds in other EU countries.
Depositary is one of the major components of AIFMD and UCITS V, but these Directives require depositaries to be located in the same EU member state as the fund. Some UK-headquartered depositaries have multiple branches and offices throughout the EU, and Brexit will require such providers to reorganise themselves if they service onshore EU AIFs and UCITS. This may be through increasing their headcount in certain EU countries at the expense of the UK.
However, the UK is probably not going to abrogate depositary rules. Any access to European markets may rest on the concept of equivalence. If the UK revokes depositary standards, this would probably result in the European Securities and Markets Authority (ESMA) rejecting the UK’s regulatory regime as non-equivalent. Even so, it may still be necessary for the depositary to be domiciled in the EU member state where the manager conducts most of its marketing (i.e. the AIFMD member state of reference rules which apply to non EU managers).
Equally, the UK is likely to expect domestic managers marketing non-EU funds into the UK itself to comply with something akin to the current depositary-lite model. The same may also be true for EU managers of EU funds selling to UK investors. There is a good chance that the depositary requirements will be retained by the UK although there may be some nuances that emerge over time.
In the short term, national private placement marketing regimes (NPPR) will continue to enable the marketing of non-EU funds in Europe. However, if third countries receive AIFMD equivalence and the ability to passport funds freely, NPPR will be phased out as will depositary-lite with firms needing to migrate to a full depositary model. Originally, this phase out was due to take place three years after the initial extension of the passport.
However, one of the many implications of Brexit is that AIFMD passport talks with third countries have been kicked into the long grass. There is likely to be a correlation between Brexit negotiations and equivalence discussions. In other words, if Brexit/equivalence talks drag on indefinitely, depositary-lites could continue to remain a feature for longer than originally anticipated.
But if Brexit talks conclude quickly and NPPR is halted without passports being offered for whatever reason, the depositary-lite set-up could be finished in the EU. The same applies if equivalence negotiations are successful and the passport is introduced for third countries.
The absence of predictability puts UK depositaries and depositary-lites in an awkward situation. Some may look to establish fully capitalised entities in the EU and some depositary-lite businesses may seek to become full depositaries. This requires forward planning and firms are advised to begin the process soon given the time it takes to register and obtain regulatory authorisation for setting up a depositary in the EU. Other businesses could question the value of remaining a depositary/depositary-lite and follow the lead already taken by one large administration group to exit depositary altogether.
The depositary margins for some firms, particularly those that have not attained critical mass of clients, are not high. These types of organisations are the ones most likely to exit from depositary work, especially if they do not feel comfortable taking on the extra cost and risk. Exiting depositary-lite would give those firms a chance to focus on other, more profitable and predictable parts of their business. Fund administration – unlike depositary – is less likely to be affected by Brexit.
But are there any positives to be gleaned from Brexit? Some have proposed creating a credible alternative investment funds regime in the UK which could compete with offshore centres such as the Cayman Islands, but not subject to the same level of regulation as onshore EU funds. Equally, NPPRs have been beset with confusion and administrative headaches in the EU and this has deterred third country fund managers from marketing to EU investors. The UK was already one of the simplest jurisdictions for third country firms to use NPPR, and this is likely to continue going forward.
Join INDOS Financial at GAIM Ops Cayman 2017
GAIM Ops Cayman is a leading conference for hedge fund operations and compliance professionals.
This year’s event takes place at the Ritz Carlton in the Cayman Islands between April 23 – 26.
Bill Prew, CEO of INDOS Financial Limited, will be discussing the firm’s experience as a depositary since AIFMD was introduced in 2014, and how managers, fund boards and investors have benefited from the service.
Contacts of INDOS will receive a 10% discount on the booking fee. Please quote code: FKN2486EMSPK to claim the discount. Bookings can be made online, via email at email@example.com or by telephone on 00 1 888 670 8200.
Please visit the event website to view the latest agenda and speaker line-up.
We look forward to seeing you there.
Predictions for the alternative fund depositary market in 2017
INDOS Financial sets out its predictions for the alternative investment fund depositary market in 2017.
Managers to continue to review performance of depositaries leading to further provider change
In 2016, we saw a number of high profile managers evaluate and change depositary as they sought to improve the service quality and value they obtain from their providers. We expect this change to gather further momentum in 2017.
Increasing focus and investor awareness about the role of the depositary
Awareness of the role and benefits of the fund depositary among investors and consultants continues to grow. When introduced in 2014, the depositary was an entirely new requirement for many funds. Given the depositary’s fiduciary duty to protect their interests, investors are asking more questions about the role of the fund depositary. As a result, there is an increasing level of investor due diligence on depositaries which will continue in 2017.
Increasing focus on the conflicts of interest in the affiliated fund administrator / depositary model
Investors and managers will continue to focus more on the potential conflicts of interest between depositaries and other service providers. Very few depositaries are willing to act unless an affiliated entity is the fund administrator. This presents a conflict of interest particularly in the area of oversight around NAV calculation and shareholder transactions. Depositaries are being required to demonstrate how they manage this conflict to ensure that the interests of the fund and its investors take priority over the interests of the depositary and affiliates within the same group.
Fund Depositary businesses will continue to reassess their commitment to the market
In 2016, one provider affiliated to a large global fund administrator exited the fund depositary market, with the administrator preferring to partner instead with INDOS Financial as an independent fund depositary. Further exits are possible in 2017, particularly for firms that have not achieved scale or profitability in those non-core business units.
Continued delays to the extension of the AIFMD passport to non-EEA funds and managers
We expect continued delays to the extension of the AIFMD marketing passport to non-EEA funds and managers, in large part due to Brexit. At present the passport is only available to EU managers of EU funds. If the passport is extended, and managers wish to avail of it as opposed to continuing to market via private placement on a country by country basis, managers will need to comply with the full depositary requirements, rather than the so-called depositary-lite model. The European Securities and Markets Authority (ESMA) has now made recommendations that equivalence be given to a handful of third countries under review. However, the decision lies with the European Commission and no word has come from them yet on the topic. Brexit will most likely lead to further delay.
Private placement and the depositary-lite model set to continue
Under AIFMD private placement can be phased out three years after the extension of the passport. Depositary-lite will continue for as long as there are delays in the extension of the passport and certainly beyond the original 2018 phase out date. Brexit may also have some impact on the future of private placement in Europe for UK managers.
Depositaries will start to adapt for the outcome of Brexit
Brexit poses significant uncertainty, but depositaries are already beginning to adapt. Depositary is one of the major components of AIFMD and UCITS V, but these Directives require depositaries for EU funds to be located in the relevant EU member state. Some UK-headquartered depositaries have multiple branches and offices throughout the EU, and this will require these providers to reorganise themselves if they service EU funds outside the UK. A lot also depends on how much of AIFMD legislation, including the fund depositary requirements, is ultimately retained by the UK. The UK may retain depositary in order to demonstrate equivalence to access European markets, or because it sees the depositary function as important for investor protection and component of good fund governance.
Depositary derogation to end by 22 July 2017
Article 61(5) of the AIFMD contained a derogation which allows, until 22 July 2017, an EU credit institution to act as a depositary to an EU alternative investment fund in another member state. After this date, EU domiciled funds are required to appoint a depositary domiciled in the same country. Some depositaries that currently act for these funds will establish depositary businesses in new EU countries to enable continuity of service however, managers in a number of countries that initially made use of this derogation may need to make alternative arrangements from July.
ESMA to conclude asset segregation review
We expect ESMA will finally conclude its review of asset segregation under AIFMD. Article 90 of the AIFMD imposes asset segregation obligations on depositaries and any appointed sub-custodian. ESMA first consulted on asset segregation under the AIFMD in December 2014 but the majority of respondents objected to the options on which ESMA consulted and therefore it carried out a further consultation in July 2016. It remains to be seen whether ESMA will require more segregation through the custody chain which would have a significant operational impact for managers, custodians and prime brokers or whether firms will be able to opt in to increased segregation.
INDOS Financial is a leading independent provider of AIFMD depositary services to alternative investment funds managed by EU and non-EU alternative investment fund managers. INDOS Financial was the first AIFMD depositary to be authorised by the FCA in January 2014 and since then has grown rapidly to service over 50 clients, 75 funds and fund assets in excess of $13bn. Funds span open and closed ended hedge funds, private equity, real estate and other types of alternative funds.