Forcing PBs to segregate AIF assets could cause serious challenges
Forcing prime brokers to segregate AIF assets could have serious unintended consequences and will ramp up borrowing costs for those firms.
The European Securities and Markets Authority (ESMA) is due to meet on July 9 to formulate a common position although given the imminence of the Alternative Investment Fund Managers Directive’s (AIFMD) deadline of July 22, any decision on the matter could be pushed back to autumn.
“It will be very cumbersome for the prime brokers if ESMA requires them to segregate AIF assets from non-AIF client assets as well as from proprietary assets. The prime brokers do not, generally, have the infrastructure and plumbing in place to readily re-hypothecate assets held in segregated accounts. The current model operates on large blocks of assets being transferred en-masse. In the short-term and if ESMA goes down this path, we could see AIFs struggling to obtain financing, or having their financing costs rise dramatically,” said Roger Fishwick, director at Thomas Murray Data Services, a firm offering depository banks a monitoring service of its network of custodian, prime brokers, markets, depositories and transfer agencies.
Article 21 of AIFMD subjects full-scope depository banks to strict liability for loss of assets. It also requires sub-custodians of depositories to segregate client assets from their own assets and those of non-AIF clients to enable the depository bank to clearly identify those assets. Prime brokers have argued that segregation does not enhance investor protection although ESMA has written to the prime brokers asking for proof that segregation will lead to additional operational complexity and added costs.
“While it is difficult to ascertain what ESMA will say, one potential compromise could entail prime brokers being required to offer segregated accounts to AIFs, but giving AIFs the choice to have their assets parked in an omnibus account and maintain the status quo. It would be a replication of the central counterparty clearing house (CCP) model whereby CCPs are required to offer individually segregated client accounts, but there is no obligation on the client to take up the option,” continued Fishwick.
Any limits on financing would adversely impact the performance of AIFs. It would also make the cost of doing businesses far higher. Initial AIFMD compliance costs alone for individual managers, according to a study by BNY Mellon Alternative Investor Services, is reported to average between $300,000 and $1 million. However, segregation is unlikely to have a material impact on prime brokerage. “AIFs will comprise a small percentage of the prime brokers’ clients. Most of the customers of prime brokers are domiciled in offshore jurisdictions and based outside of the EU so do not fall under AIFMD’s remit,” explained Fishwick.
Nonetheless, prime brokerage is facing enormous challenges. A J.P. Morgan white paper in 2014 said attempts by prime brokers to reduce their dependency on short-term funding, hedge fund and investor restrictions on re-hypothecation of collateral and Basel III capital requirements, were all going to lead to an increase in the cost of financing. There is also a strong possibility regulators in Europe could clamp-down on re-hypothecation whereby they will impose a 140% cap similar to that of the Securities and Exchange Commission (SEC).