Custodians warn on hedge fund services if Brussels acts harshly
Custodians say that hedge fund managers and clients will suffer if Brussels acts too strictly on the custodianship of fund assets.
Service providers warn their work for European hedge funds could be adversely affected if Brussels adopts the inflexible proposals currently being discussed around the custodianship of fund assets.
The providers say it will be European funds and investors who will suffer as a result.
Dealing with regulation is a pressing issue for hedge managers and service providers.
A recent survey of offshore fund managers by RBC Dexia Investor Services found about half had not moved any funds onshore, as many did not see any “significant benefits in more regulated hedge funds,” said Jean-Michel Loehr, RBC Investor Services’ chief for industry and government relations.
Chris Adams (pictured), head of hedge fund solutions at BNP Paribas Securities Services, says: “There is no doubt regulations are driving the industry.” He cites bodies of law such as Dodd-Frank in the US and Europe’s AIFM directive.
The publication this month of AIFM’s Level 2 measures will clarify how far custodians must assume liability for guarding hedge client assets.
If it forces custodians to assume full liability, the providers could simply stop servicing in markets where this entails most risk chiefly emerging markets, for which manager and investor appetite is strong.
Emerging markets hedge managers took in enough new money this year to breach previous peak assets, and run $122bn.
Adams says: “I hope common sense will prevail and regulators will not move the major players out of the market, because that would not help anyone. Regulation can drive concentration into an ever smaller number of participants, which can create systemic risk.”
David Aldrich, managing director at BNY Mellon, says if a strict ruling comes in the AIFM directive, ultimately investors and hedge funds will lose out.
Responsibilities of custodians have been diluted in redrafts of the directive already. But Aldrich says: “If Brussels takes a prescriptive approach upfront on the legislation, it makes it very difficult to work as a hedge fund custodian for European-domiciled collective investment schemes.”
In some scenarios, a custodian could do its job properly but still suffer if there is a loss event; particularly in emerging markets, he says.
A large part of the issue around the liability relates to segregation of client assets, and how or if the concept of segregation is understood in developing markets.
Aldrich gives this example: “If a depositary is required to segregate all assets under the directive, and your assets are not segregated in cases of insolvency either because there is no concept of segregation, or it is not recognized or standard in the relevant market [then] even if you perform your duties properly as custodian, there may be a loss event in [those] emerging markets.
“When, as a fund manager, you give assets to a custodian and, under the appropriate local laws, the assets are co-mingled and not segregated; even if you work to the highest standards of due diligence to protect your clients’ assets, if the local sub-custodian becomes insolvent the assets may still be lost.”
Some international custodians have been moving sub-custodian business to more globally recognized names, to improve security and visibility in the whole process.
A change in risks
The dangers for managers are that global custodians could reduce their exposure to such liability and the relevant markets partially or wholly, or that they will charge hedge fund clients more for the extra risk they are taking.
“What we cannot continue to do is accept greater regulatory risk for the same fee income,” says Adams.
“If parameters change for us, we need to understand the risks of that, and also to agree with clients the degree to which they have changed.”
Fund managers and custodians have lobbied Brussels strenuously. Aldrich emphasizes depositaries are “not trying to shirk responsibilities towards investors, or reduce liabilities currently freely entered into by contract. On the contrary, investor protection is part of the DNA of trust banks. However, it is unrealistic to expect providers to take on liabilities for things beyond their control.”
Adam paints Europe’s AIFM directive as part of broader trans-Atlantic regulatory activity to regulate areas of markets watchdogs regard as a risk to the system:
“We are seeing lawmakers on both sides of the Atlantic understanding that they cannot act in isolation when they are seeking to mitigate systemic risk. What [the collapse of] Lehman Brothers showed was that UK bankruptcy laws treated Lehman’s assets very differently to equivalent laws in the US, and that anything that builds complexity or uncertainty in this respect is to be avoided.”