The rules for asset segregation under the Alternative Investment Fund Managers Directive (AIFMD) may have an adverse impact on tri-party collateral management.
The European Securities and Markets Authority (ESMA) is planning to issue guidelines setting out requirements for the segregation of alternative investment fund (AIF) assets. If these guidelines include the segregation of AIF assets from other client assets in the sub-custodian’s books, we believe this will increase operational costs, potentially add systemic risk, and have an adverse impact on tri-party collateral management.
The main AIFMD legislative text was published in the Official Journal of the European Union in July 2011. It was supplemented by a more detailed Delegated Regulation that was published in March 2013. With the public policy objective of improving investor protection, AIFMD requires depositaries for AIFs to segregate in their own books AIF assets from non-AIF assets.
Controversies around AIFMD and asset segregation relate to the degree to which the segregation requirements placed on the depositary have to be replicated down the custody chain to the sub-custodian level. This is an important point as the final set of AIFMD segregation requirements may also apply to UCITS (Undertakings for the Collective Investment in Transferable Securities) under the UCITS V Directive.
These questions arose via the consultation paper published by ESMA in December 2014 (ESMA/2014/1326, “Guidelines on asset segregation under the AIFMD”). ESMA will determine what any future guidelines might say in this respect. The industry is waiting for final guidelines as to whether the segregation by AIF requirement would be mandated throughout multiple layers of the sub-custody chain.
While ESMA contemplated five options in their consultation paper, they have, as of the paper’s publication date, broadly discounted Options 3, 4 and 5. Public response to the paper demonstrates the broad industry consensus that Option 4 should be permitted, but that overall, the industry requires flexibility to utilize all five options as necessary to achieve investor protection.
Final guidance from ESMA is expected in Sep/Oct 2015. Until then, the standard and accepted industry practice of utilizing client omnibus accounts at lower levels in the sub-custody chain will remain.
With asset segregation throughout the sub-custody chain, the tri-party collateralization process will change significantly. Currently, tri-party collateral management uses a combination of client omnibus accounts and books and records segregation (vs. external movements) which allow for the internalization of settlement. Books and records segregation identifies which assets belong to the collateral provider (unallocated) and which belong to the collateral receiver (allocated). Internalizing the movement of collateral at the tri-party agent gives the agent the flexibility to:
If AIFMD asset segregation rules require that AIF assets and non-AIF assets be held in different accounts at a sub-custodian, then this would prevent internalization of settlement, and tri-party agents would have to send individual settlement instructions to the sub-custodian for every collateral allocation to an AIF client. These settlement instructions would need to be processed not only in the tri-party agent’s system but also throughout the sub-custodian chain, exposing the business to external movements and external deadlines.
We are raising this systemically important issue not just from a financial service provider’s perspective, but more importantly, as an issue for the real economy and market participants (notably pension funds, asset managers and other providers of savings vehicles) who would be adversely affected by these proposals and who would not receive any clear identifiable benefit.
Our view is that the proposal for asset segregation throughout the custody chain is predicated on the following premises.
We believe that both of these premises are misleading.
We believe that segregation in established books and records can achieve investor protection, and that segregation in accounts throughout the sub-custody chain introduces additional operational and settlement risks to the investor. Segregation would also introduce settlement delays, increase counterparty exposure and significantly impede the collateral substitution, optimization and movement process.
In addition, segregation at the sub-custodian level would have a number of unintended negative consequences, including the following:
If you would like more information on AIFMD and tri-party collateral management, please contact your Relationship Manager.
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