ALFI Luxembourg: Depositaries could shun some funds of funds due to AIFMD Level 2 liability concerns

Fund AdministrationInvestorsOperational RiskRegulation
22 Nov, 2012

Depositaries could be forced to rethink some of their relations with funds of funds because of the strict liability requirements mandated under the AIFMD Level 2 provisions, experts have warned at ALFI Luxembourg.

European funds of funds’ investments registered in the name of the depositary will be considered as assets held in custody thereby forcing liability on the depositary for any losses or frauds committed by the fund registrar.

“Some funds of funds, which will have to have their target funds registered in the name of the depositary, might be viewed as high risk which is going to force depositaries to conduct a greater, and indeed intrinsic level of due diligence on those funds’ registrars. This could reduce the amount of products or funds of funds which depositaries service,” said Jean-Michel Loehr, chief industry and government relations at RBC Investor Services.

Nonetheless, funds of funds registered in the name of the fund will absolve depositaries of this liability. “Funds of funds registered in the name of the fund itself will obviously not have this issue because their assets are not in custody,” said Mark Mannion, head of relationship management and sales at BNY Mellon AIS.

Depositaries are understandably nervous about the implications of these liability rules. “AIFMD gives depositaries very few discharges from liability. Historically we have done credit risk assessments on funds of funds and single managers but AIFMD stipulates we need to carry out a fuller risk assessment before we take on a manager,” said Bill Scrimgeour, head of regulation and government affairs at HSBC Securities Services.

Obtaining relevant data on funds of funds' underlying managers will be a huge challenge for some depositaries. “Not only do the depositaries need to understand the strategy but they need to clearly comprehend the underlying assets at funds of funds’ hedge funds. Depositaries will need to get this information from hedge fund administrators. This is a significant amount of work,” commented Scrimgeour.

The issue will be particularly acute for funds of funds invested in hedge funds, which self-administer although the majority of funds of funds view self-administration at hedge funds as an automatic red flag in light of Madoff. One expert said certain depositaries had compiled a list of approved fund administrators which met their due diligence requirements.

Nonetheless, talk about depositaries shunning hedge funds focused on emerging markets, was disputed. “Debate about whether certain perceived high risk markets will be shut has been exaggerated. We have conducted extensive research and just two markets might be impacted,” said Scrimgeour, although he did not disclose which ones.

AIFMDALFIBNY Mellon AISdepositary liabilityfunds of fundsHSBC Securities ServicesLevel 2LuxembourgRBC Investor Services