Investment bankers do not expect to lose arguments to anyone, so it took robust and lengthy negotiations before the prime brokers conceded that they would have to indemnify custodian banks against the losses of assets in their care.

A spectre haunts the memory of the global custodians that are taking on the bulk of the depositary work prescribed by the Alternative Investment Fund Managers Directive (AIFMD). It is the 2010 ruling of a French Court that two of their number – namely, the then-RBC Dexia Investor Services and Société Générale Securities Services – should make investors whole after assets in custody with Lehman Brothers were lost when the investment bank collapsed in September 2008.The court reached this verdict despite the fact that it was the fund manager, not the global custodians, which had elected to place assets in custody with Lehman Brothers. The global custodians at no point had any control over what Lehman Brothers did with the assets either. What they did have, however, was deep pockets – and the French courts reached into them on behalf of some angry and disappointed investors.

Despite the memory, those pockets will not now be deepened by lavish depositary fees. The price of depositary services has fallen dramatically, to just one or two basis points on top of an existing custody fee, at least for those managers which do not trade exotic markets or arcane instruments or hard-to-verify asset classes. There are even reports of the universal banks offering depositary services for free if a manager purchases them as part of a bundled service offering encompassing prime brokerage and fund administration. Bill Scrimgeour, global head of regulatory and industry affairs at HSBC Securities Services in London, reckons most fund management firms are paying basis points in the low single digits in the majority of markets, rising to double digit points in higher risk markets or strategies. Depositaries are free to refuse to accept liability for assets in markets where they feel a suitable custodian is unavailable, or local laws and regulations make it impossible to do the job properly, but that remains a largely theoretical problem so far.

One area where it might stray into the field of practice is in relations with the prime brokers. Global custodians spent much of last summer wrangling with the investment banks over who would be responsible for any assets lost from prime brokerage accounts. A standard compromise emerged. Custodians are working with the top dozen prime brokers only, those prime brokers indemnify the custodians against losses they cannot control, and the custodians have also secured a discharge of their liability to make investors whole where prime broker behaviour furnishes them with an “objective reason” to escape their responsibility.

“Realistically, no prime broker wants to offer an indemnification to the custodians,” admitted a prime broker at the beginning of this year. “However, it looks like we are going to have to.” Mark Mannion, head of sales and client relationship management for Europe, Middle East and Africa (EMEA) at BNY Mellon Alternative Investment Services, agreed. “This negotiation process has moved on over the last few months and it looks like there will be some sort of agreement between prime brokers and depositary banks,” he said. “We think that it will be business as usual for hedge funds, depositaries and prime brokers when AIFMD takes effect.”

The depositary bank stance on prime broker risk was understandably robust. They were being asked to take responsibility for assets they did not control. Indeed, those assets would in most cases not even be held directly by the prime broker, but in banks appointed as sub-custodian to the prime broker in multiple markets around the world. As Brandon Bambury of KAS Bank has pointed out, sub-custodians in frontier markets do not always reach international standards, possess industry-recognised credit ratings, or even have a connection to SWIFT.

The prime broker sub-custodians also include the international central securities depositaries (ICSDs), Clearstream and Euroclear, with which the global custodians have had an awkward rivalry for decades. Investment banks in Europe like to hold fixed income assets in particular at the ICSDs, which in turn hold them through their own sub-custodian networks. This introduces a further layer of risk for depositary banks, since the sub-custodian banks chosen by the ICSDs to hold assets on behalf of prime brokers are also not necessarily ones which depositaries would retain in their own networks.

Some depositary banks have stated publicly that clients with assets in custody within the sub-custodian network of a prime broker or an ICSD will sometimes be expected to move those assets to the sub-custodian of the depositary bank, on pain of the depositary refusing to underwrite the risk. “On the matter of ICSDs, there is still a lack of clarification,” says Bill Scrimgeour of HSBC. “There is a belief that depositaries can discharge themselves from any liability held with the CSD or ICSD. However, there continues to be disagreement on this.”Whether or not depositary banks will actually be able to force clients to use their favoured sub-custodians will almost certainly never be put to the test, with adjustments occurring quietly. “Some of the depositaries have been very public about this but it is not realistic,” says a prime broker. “If one of the big depositary banks succeeds in forcing an ICSD to push assets it held in its own sub-custody network into the sub-custodian network of the bank, then every single depositary bank will start making similar demands. This will lead to an operational nightmare in the securities settlement process.”There is a more immediate operational challenge to be faced. Prime brokers holding unencumbered assets of a fund are effectively acting as sub-custodians to the global custodian banks acting as depositary. In most markets, assets are held by sub-custodian banks in an omnibus account, chiefly for reasons of operational efficiency. Unfortunately, the AIFMD insists under Articles 98 and 99 that assets belonging to investors are held in segregated accounts throughout the sub-custody chain.

In the past, even those fund managers who noticed such things were reluctant to pay a premium to obtain full segregation of their assets at the level of the sub-custodian. Yet assets are undeniably harder to retrieve in an insolvency if they are not segregated. Regulators around the world, anxious not only to protect end-investors but to tackle fraud and terrorist financing by forcing banks to tighten Know Your Client (KYC), anti-money laundering (AML) and sanctions screening procedures, have in any event earmarked omnibus accounts for extinction Under AIFMD in particular, depositary banks are charged with making sure that funds and fund managers understand the risks of investing in markets where segregation at the sub-custodian is not an effective remedy under local insolvency law (the AIFMD even exempts custodians from liability where that is the case). “Under AIFMD it is necessary for all financial instruments held in custody by the prime broker on behalf of hedge funds and their investors to be fully segregated so that, in the event of a prime broker defaulting, the depositary bank can easily obtain those assets without delay,” explains Bill Scrimgeour of HSBC.

Custodians, knowing that the economics of prime brokerage have long depended on the ability of the ability of the investment bank to borrow, lend or otherwise re-use assets managed by their clients, are understandably unconvinced that prime brokers will be keen asset segregators. “We are carefully reviewing the re-hypothecation practices at prime brokers which Northern Trust has relationships with,” explains John Cargill, head of depositary services at Northern Trust. “Our relationships with prime brokers are of strategic importance to us and, while we are not saying there is a cap, it is something we are looking at, and we shall be assessing re-hypothecation practices at prime brokers on a case by case basis.”

Any limits on re-hypothecation would lead to fund managers paying higher rates to borrow cash and securities. This is already happening, as the regulators use capital and liquidity ratios to force prime brokers to match their lending and borrowing more exactly, and assign capital to the risks they take. In the United States, SEC Rule 15c3–3 limits prime broker usage of customer securities to finance their own activities, while Regulation T caps prime broker re-use at 140 per cent of a debit balance. European regulators wish to suppress re-hypothecation too, as part of a multi-faceted campaign to crush the so-called “shadow banking” industry.Nevertheless, some prime brokers maintain a surprisingly breezy view of the asset segregation issue. “We are perfectly capable of segregating assets that we hold in custody for our hedge fund clients,” explains one. “My personal opinion is that custodians do not quite understand the prime brokerage model and how it operates. In the custody model, they simply hold assets in one big box, which is not the case in prime brokerage. At present we have had no pressure from depositaries about our re-hypothecation practices. I honestly do not believe we will be pushed by the depositaries to reduce our re-hypothecation as our rates are already at the 140 per cent level.”

Bill Scrimgeour of HSBC agrees that the custodian bank has not yet told any prime broker to scale back its re-hypothecation of fund assets. But any depositary assuming liability for investor assets is going to want full disclosure of what the prime broker is doing with them. “We want to know exactly where, which and what value assets are being held and we shall be reviewing what the prime brokers tell us on a daily basis,” says Charles Bathurst, board advisor at SuMi TRUST, a division of Japan’s Sumitomo Mitsui Banking Corporation. “We will look carefully and regularly monitor the daily levels of re-hypothecation at prime brokers and the valuation of assets placed on these. We will be checking this ourselves and we do not want to simply rely on reports from the primes and take these simply on face value.

”Disclosing that sort of information will not come naturally to prime brokers, since it offers insights into trading positions, “Our priority is to protect investors in a fund and, if a service provider does not meet our risk standards, then that could be a problem,” says David O’ Keeffe, director of the depositary at SuMi TRUST in Dublin. Shane Ralph, a director at State Street in Dublin, agrees. He says hedge funds using prime brokers that do not meet minimum standards set by the bank would be advised to switch to a different provider, given the liabilities the depositary is taking on. If a manager refused to change, that could lead to a depositary terminating its relationship with a fund.

Nobody in business ever seeks opportunities for that to happen. This explains why depositary banks have chosen to work with a limited number of prime brokers rather than manage the problem after the event. “The choice of prime broker is ultimately the hedge fund manager’s decision,” says Pete Townsend, head of hedge fund solutions at BNP Paribas Securities Services. “A depositary such as ourselves can raise a red flag to the AIFM if we uncover any potential breaches in our agreement with a prime broker, but changes to prime broker appointments are the responsibility of the AIFM.”

Nevertheless, smaller fund managers using second tier prime brokers that wish to obtain an AIFMD licence are being restricted to the list of prime brokers deemed acceptable by the major depositary banks. They are also in a weak negotiating position if deterioration in the creditworthiness of a prime broker forces them to change provider, effectively at the behest of a depositary bank.

Since an AIFM must have a depositary in order to trade, any inability to appoint a replacement promptly - and even in benign markets, the process might take several months - would force the firm to stop trading and liquidate its holdings. It is not fanciful to foresee fund managers and their investors suing depositary banks that force changes which result in a business unravelling. AIFMD retains its potential to unsettle established relationships between fund managers, their investors and their service providers