Brussels: European Commission rejects industry complaints on depositary liability
The European Commission has hit back at industry claims that depositary liability will be prohibitively expensive.
EU not backing down on AIFMD
Managers hoping to access EU investors must appoint a depositary by July 2013. AIFMD requires a depositary, most likely a major custodian bank, to oversee funds and safeguard assets. They will be held liable for any losses incurred at the sub-custody level either through fraud or insolvency. Industry figures have argued it is unfair to make custodians liable for events outside of their control. Depositary liability has proved controversial with AIMA speculating it could cost up to $6 billion.
Speaking in Brussels, Tilman Leuder, head of the asset management unit at the European Commission, disputed these claims. “Our experts state that the extra cost of capital that is claimed by depositary associations does not arise. We checked this and liabilities incurred for the loss of financial instruments do not give rise to extra capital requirements. Furthermore, we reject the argument that it is difficult for custodians to effectively monitor their sub-custodians. If they believe there is a risk of fraud or default at a sub-custodian, then that custodian should not appoint them,” he said.
Furthermore, Leuder said the likelihood of a loss at the sub-custody level was minimal. “It is very difficult for a financial institution to lose an instrument which they are holding on behalf of a fund because all of this is done electronically. The fact there are electronic records means that the risk of fraud is diminished. Data or instrument loss in the event of a programming error is the only scenario I can think that poses a plausible risk,” he said.
Others have expressed concern that depositary liability could exacerbate systemic risk by concentrating assets with a handful of major custodian banks. Again, this was refuted by Leuder. “There are five main players who are going to be truly affected and these five banks were already highly concentrated and systemically important. The directive is not adding to that. Furthermore, these banks will not be required to set aside additional capital to comply with the directive so systemic risk will not increase,” said Leuder.
Only certain managers will be required to appoint a depositary. AIFMD exempts managers based in a member state operating an offshore vehicle providing they market their products in their home jurisdiction only (although this is still subject to local law – France and Germany, for example will require the manager to appoint a depositary while the UK will not). Managers operating outside of the EU and not marketing inside the EU would also be exempt.
The Commission’s proposals on intergovernmental cooperation have also alarmed experts in some jurisdictions who have accused the body of extraterritoriality. The rules appeared to require third country regulators to impose EU law in their jurisdictions if managers are to be allowed to market to EU investors.
“If a manager operating out of a third country wants a passport to access EU investors, then that manager has to be compliant with AIFMD and not the country. When managers delegate management tasks to third countries then it is expected that those delegates in those third countries are subject to prudential rules. EU domiciled managers may also appoint a non-EU depositary but that depositary must also meet EU standards and be subject to prudential supervision,” he said.
Private placement has often been bandied as a carrot to the industry although several observers have pointed out national regulators, particularly the French and Germans, could impose restrictions on private placement. “I have not heard of any national regulators considering such a move,” said Leuder.
Mandatory leverage limits have also irritated some commentators. AIFMD’s Level 2 rules state that hedge funds must report to ESMA if they breach leverage limits which are currently set at three times the NAV. ESMA could then have the right to impose mandatory leverage limits on funds during bouts of market stress, or if they believe a particular manager poses a systemic risk. The methodology employed by ESMA to calculate leverage (put crudely it will add the hedge fund’s balance sheet to any notional underlying derivative positions and then divide it by the NAV) could make managers appear more levered than they actually are, according to AIMA.
“Our latest proposals on how to calculate leverage are based on the tried and tested approaches taken in Ucits. The so-called gross and commitment methods for calculating leverage are nothing new at all and were proposed by ESMA, the successor body to CESR which proposed the leverage methods in Ucits. There is nothing odd or unusually strict about our proposals and I do not see anyone becoming 'ensnared' by them,” said Leuder.
Curbs on remuneration could prove to be an upset. AIFMD proposals could force hedge fund employees to defer between 40% and 60% of their bonuses over several years while a substantial portion of their packages must be paid in shares. According to ESMA, this will disincentivise short-termist behaviour. However, unlike investment banks, hedge funds do not pay bonuses but performance fees, which are not arbitrary. Furthermore, the majority of managers are partnerships and paying employees in shares is not feasible. Leuder said ESMA was still working to finalise the remuneration guidelines.