ESMA publishes consultation on asset segregation
The European Securities and Markets Authority (ESMA) has published a consultation paper outlining options on asset segregation under the Alternative Investment Fund Managers Directive (AIFMD).
The consultation, which will run until January 30, 2015, identifies two options. Option one would require AIF assets to be held in segregated accounts at the delegated third party if those assets are held on behalf of multiple depositary banks. For example, if a prime broker was sub-custodian and holding AIF assets on behalf of four AIFMD depositary banks, it would be required to open four segregated accounts.
The second option would require the prime broker to segregate AIF assets held on behalf of depositaries from those of non-AIF assets, in what would effectively be a super omnibus account structure for AIF assets. “The two models ESMA proposes are diametrically opposed with only one allowing depositaries to do their jobs properly – through segregation at the depositary level,” said one regulatory expert.
The second option offered by ESMA will undoubtedly frustrate the depositary banks, as it will not give them a clear line of sight over assets held at the prime broker, and therefore could impede their ability to provide restitution of assets to investors in the event of a loss or fraud at the sub-custodian level.
Some had hypothesised prime brokers would be required to separate AIF assets from non-AIF assets on a fund-by-fund basis. Such a scenario would have caused serious operational challenges for prime brokers as they lack the internal infrastructure to re-hypothecate collateral held in separate accounts. This would have added to the travails at prime brokers, many of whom are struggling with re-hypothecation restrictions being imposed on them by hedge funds and investors, as well as the Basel III capital requirements.
Compromise, does, however, have to be reached. Alex Harborne, a senior analyst at Thomas Murray Data Services, argued in his latest white paper, that prime brokers be required to offer segregated accounts to AIFs while simultaneously permitting AIFs to choose whether they want assets parked in a segregated account or to retain the status quo. This in effect mimics the model adopted by central counterparty clearing houses (CCPs) whereby CCPs are required to offer individually segregated accounts but the client is under no obligation to take it up.
Other challenges continue to remain. Depositaries have sought discharge of liability agreements and indemnifications from sub-custodians excusing them from responsibility for losses in exceptional circumstances. These are legally untried and untested. “It remains to be seen what will happen to full discharge of liability once guidance is given which cannot be in the interests of investors who would want their assets back in an insolvency situation,” said the regulatory expert.
ESMA said it will aim to publish a final report on the guidelines in the second quarter of 2015.