NatWest says time is ripe for funds to appoint independent depositaries
A serious conflict of interest has arisen in the European funds industry. This is the tendency of fund management companies to entrust both the safekeeping of client assets and the protection of investor interests to other arms of their own organisation. NatWest Trustee and Depositary Services (NatWest TDS) provides a ready-made alternative.
It seems incontestable that any organisation purporting to act on behalf of investors should be independent of the organisation that manages or safekeeps the assets belonging to those investors. Yet it is surprisingly rare. The majority of European mutual and alternative funds domiciled in Ireland and Luxembourg appoint as both custodian and depositary – the European term for the trustee that looks after the interests of investors - the banking arm of the same organisation that manages the funds.
Throughout the entire European asset management industry, from orthodox mutual funds, through the managed funds offered by private banks, to alternative funds, this practice is commonplace. Investors find their financial assets are not only managed, valued and custodied by different arms of the same organisation, but that their interests are represented and protected by a fourth arm of exactly the same organisation.
It was this obvious conflict of interest which sparked one of the more interesting debates ahead of the passage of the fifth iteration of the Undertakings for Collective Investment in Transferable Securities Directive (UCITS V). After all, both the Madoff fraud and the Lehman Brothers insolvency had exposed flaws in the European depositary model. Officials at both the European Commission and the European Securities and Markets Authority (ESMA) pondered making it mandatory for every European mutual fund to appoint a depositary that was genuinely independent.
Clearly, unravelling the conflicts would have cost a great deal of time and money, and fund managers and custodian banks lobbied heavily against the idea. So nobody was surprised when the regulators agreed that yet another a variant of the Chinese Wall - the device erected to solve every conflict of interest since the invention of universal banking - provided an acceptable (if predictable) compromise. Depositaries to UCITS funds are now under an obligation not to actually be independent, but merely to act independently.
Yet the arguments for a genuinely independent guardian of the interests of investors remain robust. As it happens, one organisation which is genuinely independent has survived all of the mergers that have taken place in the United Kingdom fund administration and banking industries. NatWest trustee and depositary services (NatWest TDS) are currently protecting the interests of circa £330 billion invested in funds by investors in the United Kingdom.
Importantly, NatWest TDS is not a custodian bank or a fund administrator. Its parent, RBS, sold its custody business before it even acquired NatWest in 2000, so NatWest TDS is at bottom a trustee of the kind once familiar in the British and Irish mutual fund industries - one of whose roles was always to appoint and monitor the custodian to the assets of a fund. Today, however, the commonest model is for a fund to buy custody and trust services as part of a bundled package.
Andy Wright, head of trustee and depositary services in the transaction services division at RBS, argues that the lack of accompanying investor services is one of the principal advantages of his offering – not just because independence is desirable in principle but because it also frees the bank to work with all service providers. "The purest interpretation of the regulations is for independence," he says. "Certainly we feel well-positioned. Being independent enables us to work with a cross-section of the industry, including global custodians, fund administrators and transfer agents."
One measure of the commitment of NatWest TDS to its independence is the fact that it benchmarks the custodian bank and fund administrators it works with. Wright argues that this benchmarking promotes the virtues of independence and raises standards of governance. "An unbundled offering has advantages for investors, and we believe wider adoption of independent providers is not only good for our business, but will help to drive up standards of governance and investor protection in the industry as a whole," he says. "There is no other major market in Europe where independence is as commonplace as it is in the United Kingdom."
This might be interpreted as an oblique reference to the difficulties experienced by a number of Luxembourg-based depositaries to funds invested in securities and money market instruments issued by Lehman Brothers at the time of its demise in 2008. Indeed, it is remarkable that, despite that experience, the Alternative Investment Fund Managers Directive (AIFMD) permitted the creation of so-called "depositary lite" services to funds which did not wish to incur the expense of a full depositary.
Despite the determination of Ross McEwan – the CEO of NatWest parent RBS - to re-focus the bank on the domestic markets of the United Kingdom, spreading the gospel of independence to continental Europe is clearly part of the growth strategy at NatWest TDS. It makes sense. The bank is largely a UCITS depositary already, with around 75 per cent of the 1,100 or so funds it services structured as UCITS funds.
"UCITS V is a huge opportunity for NatWest TDS," says Peter Christmas, business development director in trustee and depository services at NatWest since the early part of this year. "When the Level II measures were published in March this year, but effective only from October, we decided to become Level II-compliant immediately."
It helped that NatWest had already developed most of the services necessary to be a UCITS V depositary as a result of adapting its offering for clients managing funds captured by the AIFMD, which came into effect in July 2014. Many of the remaining 25 per cent or so of funds serviced by NatWest - around 300 separate funds in total - were caught by AIFMD. For depositaries, UCITS V largely extended the duties of an AIFMD depositary to UCITS funds, so adapting to the new rules was not difficult for NatWest TDS. "We were already providing these services under United Kingdom trust regulations, let alone AIFMD, so becoming UCITS V compliant was not difficult for us," says Wright.
Being UCITS V compliant - and the United Kingdom gold-plated the local implementation of it - could well become an axis into Continental Europe, if European fund regulation unfolds as expected. At the moment, UCITS funds are still obliged to appoint a depositary based in the location where they are domiciled, but future European regulations such as the anticipated UCITS VI and AIFM II directives are expected to introduce the concept of depositary passporting. This would allow funds domiciled in Ireland and Luxembourg to appoint NatWest TDS as depositary to funds.
“Once depositary passporting is permitted in Europe, we think we have a big opportunity to extend our model into Europe,” says Wright. “The services we provide are entirely compatible with the responsibilities of a depositary bank under UCITS V or the AIFMD, such as appointing and monitoring the custodian, fund accountant and transfer agent, and overseeing the fund manager. The concept of independence is not yet widely accepted in Europe, but we think it will become a more important buying criterion among managers, because intuitively it looks better to regulators and increasingly to investors as well."
As it happens, RBS has a depositary business in Luxembourg, servicing the locally domiciled alternative funds of managers based largely in the United Kingdom, though also elsewhere. So even without a passport, RBS has the ability to provide AIFMD-compliant depositary services - namely, cash flow monitoring, safekeeping and compliance monitoring - from Luxembourg as well as the United Kingdom.
Another potential avenue of growth is the alternative funds sector regulated under AIFMD, which now also have to appoint a depositary. With many traditional managers now expanding into these alternative strategies, NatWest TDS can grow into this sector alongside existing clients. The same is true of a group of other novel strategies: the burgeoning real estate and infrastructure fund sectors, where growth is fueled by a mixture of government policy and low rates of interest. "As our strategy evolves we would expect to work with more private equity funds, but RBS has clients investing in those sectors already," says Wright. “They are a natural audience for us to work with in the short term.”
How helpful independence will prove in winning business of any kind remains to be seen, but Peter Christmas says it is resonating already with funds which attach value to asset safety. "We are in a position where there is no conflict with anyone in the value chain," he explains. "If we have concerns, we can raise it with the service provider, the fund as client, and ultimately the regulator. Bundled providers have to deal with an inherent internal conflict."
Independence means the pricing of trustee and depositary services is unbundled too. This can of course be problematic, because competitors are able to subsidise depositary prices with revenue from custody, fund accounting and transfer agency. "Competing against cross -subsidisation can make it harder to win business, but all the cultural and regulatory drivers indicate managers should choose independent providers," says Christmas. "Regulators value transparent pricing too, and that is harder to demonstrate with bundled fee structures."
Christmas says funds are already approaching NatWest TDS for guidance, precisely because they are independent. "As depositary, we have a responsibility to ensure client assets are protected," adds Wright. "While we have that responsibility, we delegate the actual safekeeping to custodians, so we have every incentive to monitor the custodians carefully. The manager appoints the fund accountant and the transfer agent, so we do not have the same level of responsibility, but we do site visits to all parts of the value chain: the fund manager, the custodian, the fund accountant and the transfer agent."
Peter Christmas adds that the NatWest TDS story is perfectly adapted to an industry increasingly alive to transparency and asset safety. "2015 was a strong year for NatWest TDS," he says. "It is a good environment in which to be selling independence. There are lots of opportunities to explain the benefits of independence. We are doing a lot of educational work via seminars and conferences to bring our knowledge and our independence to the attention of customers."
The recruitment of Christmas is also a sign that NatWest TDS parent RBS is taking the depositary role seriously. TDS was shifted from the corporate and institutional division of RBS in October, to emphasise its independence from the investment banking and asset management businesses of RBS. It is now part of the transaction services division of the commercial and private banking division of the RBS group, which is led by Alison Rose.
Peter Christmas is finding the new divisional berth a useful platform in the search for cross-selling opportunities. "I am talking to other parts of the RBS group that have relationships with funds in other lines of business, to consultants who advise fund managers, to independent fund administrators and to custodians which do not have a depositary business of their own," he says. "My role is to increase the visibility of the brand, and the heavy focus in the asset management industry on fund governance is making it a lot easier to raise the profile of our principal value proposition: independence."
© Dominic Hobson