I was asked recently which regulation I think is having the biggest impact on custodian banks in Europe. Many people would point to the European Market Infrastructure Regulation (EMIR) or Basel III and the Capital Requirements Directive IV (CRD IV). There
is no doubt that a lot of organizations are finding it complex and costly to comply with these measures and to monitor them. However, when it comes to operational change, I strongly believe the Alternative Investment Fund Managers Directive (AIFMD) is the
most significant of the lot.
AIFMD introduces major challenges for depositary and custodian banks, which provide depositary services to alternative AxiomSL - AIFMDinvestment fund managers (AIFMs) in Europe. The hurdles they must overcome include account segregation, cash flow monitoring,
oversight duties and new liability relationships. The good news is that there are significant commercial opportunities for the most proactive banks, which take a strategic approach to implementing the necessary changes.
The segregation of client accounts is a notable departure from established practice for custodians. Until now, it has been common for custodians to re-hypothecate the assets of their clients. However, AIFMD now requires custodians to create separate accounts
for each alternative investment fund (AIF). Re-hypothecation – which is said to have been the main cause of the collapse of Lehman Brothers- is no longer an option.
This change is creating a significant increase in the number of accounts that custodians must set up and maintain. Depending on the number of AIFs and share classes managed by an AIFM, one collective account may have to be split up into dozens of single
accounts. In each case, the custodian must do due diligence work to verify which AIF owns which assets. It must then ensure all account information is kept up to date and that it can be produced on demand.
Of the new requirements I mentioned at the start, cash flow monitoring is the most challenging. In the past, depositary banks simply had to safe-keep the assets of an AIF; now they must also have oversight over all of an AIF's cash flow activity. This includes
doing daily reconciliations of cash flows and identifying those that are inconsistent with an AIF's normal activities.
From what I have seen, many banks have significantly underestimated the impact of the cash flow monitoring requirements. Some that I have spoken to had assumed that complying with these new demands would simply be a case of collecting a few additional reports.
It has quickly become clear there is much more work involved.
For example, some custodians are creating a definition of 'unusual transaction' for each AIF. They are then monitoring all of the activities of the AIF against the benchmark they have created and producing a daily report. Each time an unusual cash flow is
spotted, it must be investigated to check whether it is legitimate. This involves people from several departments, including compliance officers, operational accountants and business analysts.
In one case I am aware of, a bank has had to open a new department, hire two new people and set up ten different reports for all of the cash flow activity of its custodian arm, as well as for its funds and sub-custodians. When considered in this way, it
is clear that cash flow monitoring is a significant, ongoing overhead for depositary banks.
The most controversial of the measures introduced for depositary banks makes them liable for the loss of financial instruments they are holding in custody. There are exceptions to this new requirement. For example, a custodian is not liable if it can prove
a loss was due to an external event that was beyond its control. But it is nevertheless an unwelcome development for the banks, which requires reshaping of the contractual structure between AIFMs, depositary banks and, if necessary, custodians, prime brokers
As well as carefully reconsidering their contracts in light of the new liability arrangements, banks also need to analyze the implications for their operations and the technology they use. For example, custodians must ensure their processes are highly auditable
so they can prove they have executed all of their responsibilities.
AIFMD has certainly caused a lot of pain for custodians. However, it is clear that the directive has gone down well with investors, and those organizations that have done the most to adjust to the new regulatory regime will be rewarded with new business.
A report published last month by the Association of the Luxembourg Fund Industry (ALFI) has found that the number of alternative investment funds in Europe has increased by 10% since 2010 and assets under management have gone up by 13%. In Luxembourg, where
I am based, 169 new funds were established between 2010 and 2013 – an increase of 11%.
Marc Saluzzi, the Chairman of ALFI, has put this increase in activity down to AIFMD. Investors appear to have been attracted to Europe by the increased protection the directive offers them.
All of the new funds that are popping up across Europe are now in need of the services of a depositary bank or custodian that is fully compliant with AIFMD. The best prepared banks can therefore pat themselves on the back as the new business rolls in. Meanwhile,
for the others, there is still time to catch up and ride the wave of enthusiasm for the European funds industry.