ESMA likely to force primes to segregate AIF and non-AIF assets
The European Securities and Markets Authority (ESMA) is likely to force prime brokers to segregate AIF assets from non-AIF assets in what could have significant implications for the prime brokerage operating model.
A prime broker source familiar with the situation said a senior ESMA official had recently indicated the final rules on asset segregation under the Alternative Investment Fund Managers Directive (AIFMD) will not be well-received by the industry. ESMA has delayed a decision on asset segregation for some time now although many believe the regulator has reached its conclusion.
“The rumour is ESMA is going to enforce segregation of EU AIF and other assets. This would have a significant impact on existing prime broker operating models. Depending on the extent of the segregation requirements, we understand prime brokers could take anywhere between 18 months and two years to implement these changes. It is not clear whether ESMA will allow a transitional period,” said Bill Prew, founder of INDOS Financial, an independent depositary-lite in London.
Prime brokers, by and large, do not possess the infrastructure and plumbing to readily re-hypothecate client collateral held in segregated accounts. The current model operates on collateral being transferred from omnibus accounts en-masse. Any segregation could therefore make it harder for prime brokers to re-hypothecate AIF assets.
“We hear mixed views as to whether re-hypothecation will be impacted as a result of segregation. Ultimately prime brokers will need to adapt their models but asset segregation may, for now, only apply to EU AIFs subject to the full depositary rules. Non-EU AIFs that have implemented the depositary-lite model should not be impacted,” said Prew.
The rules are also unlikely to be imposed on a client-level. “At present banks are set up with a single omnibus account holding all of the assets and there is, broadly speaking, one standard set of settlement instructions for this omnibus account. If segregation was imposed on a client level, then the number of settlement instructions, operational work and cost would rise significantly. I doubt ESMA will require segregation to this extent,” highlighted Prew.
AIF asset segregation would certainly be welcomed by depositaries, which are subject to strict liability for any loss of assets. Depositaries argue that retrieving assets held in a segregated account as opposed to an omnibus account during an insolvency is a far more straightforward process.
However, any hindrance to re-hypothecation practices will be yet another challenge to the under-fire prime brokerage industry. Papers published by both Citi and J.P. Morgan in 2014 highlighted attempts by prime brokers to reduce their dependency on short-term funding, hedge fund investor restrictions on re-hypothecation of collateral and Basel III capital requirements are all going to lead to an increase in the cost of financing.
A study by Barclays Prime Finance said the tightening on financing would disproportionately impact illiquid or highly leveraged strategies. The study said the average hedge fund’s returns could decline by 10 to 20 basis points with fixed income arbitrage – one of the most leveraged strategies at 13 times its Net Asset Value (NAV) – being hurt the most, with returns diminishing by anywhere between 40 and 80 basis points.
The challenges around financing coincide with regulatory clampdowns on re-hypothecation. There is a strong possibility the European Commission (EC) could clamp down on re-hypothecation practices at prime brokers. Some expect the EC to emulate the Securities and Exchange Commission’s (SEC) Rule 15c3-3 which prohibits prime brokers from re-hypothecating more than 140% of a client’s debit balance, although the EC could impose a lower threshold.
The EC has already proposed Securities Financing Transaction regulation, which requires alternative investment fund managers (AIFMs) and UCITS managers to give consent to assets being re-hypothecated. The collateral giver must be supplied in writing details of the risks re-hypothecation entails by the collateral taker and this must be confirmed by written agreement; and the financial instruments received as collateral must be transferred to an account in the name of the receiving counterparty. It is believed these rules could be a precursor to something tougher down the line.