AIFMD terminology creates market confusion

AIFMD terminology creates market confusion

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The catastrophic failures of the crisis – from Bernie Madoff’s Ponzi scheme to MF Global and Lehman Brothers – have made investors and authorities focus on liability in the custody chain.

While occasional, such cases laid bare the reality that money can disappear in even the most developed and well regulated markets, leaving investors and intermediaries with crippling losses.

Improving investor protection is at the heart of the European Union’s Alternative Investment Fund Managers (AIFM) directive, which requires depositary banks to be liable for a loss of assets in its custody even when held by a sub-custodian.

Although there are exceptions to the rule, depositary banks are effectively deemed guilty until proven innocent as they must demonstrate they were not negligent in the process that led to the loss. Ucits V, due to come into force in the third quarter of 2014, is likely to be even more stringent in terms of depositary liability as it concerns the protection of investors in less exotic products.

Although the deadline for member states to implement the directive has passed, a divergence has emerged in the market over the interpretation of a short 46-word provision in the depositary liability regime when services are provided by securities settlement systems (SSS) – which are run by central securities depositories (CSDs) and international central securities depositories (ICSDs).

Article 21(11) states: “…the provision of services as specified by directive 98/26/EC by securities settlement systems as designated for purposes of that directive or the provision of similar services by thirdcountry securities settlement systems shall not be considered as a delegation of custody functions.”

When Global Investor/ISF asked the European Commission for clarification on this article, it said in an emailed statement on November 27 that the provision of securities settlement services including “(i) initial recording of securities in a book-entry system through initial crediting, (ii) providing and maintaining securities accounts at the top-tier level and (iii) operating a securities settlement system”, should not be subject to delegation of custody.

The commission went on to say that as “providing custody is not part” of these services, Article 21(11) “does not state that a depositary bank can extricate itself from liability for the loss of a financial instrument by delegating custody to securities settlement system.”

Depositary banks are left with a few options to deal with the liability. They can underwrite it in-house and set aside capital – although no standard calculation exists – seek agreement from the AIFM to classify the assets as non-bank assets, seek the AIFM’s agreement to delegate liability to the sub-custodian or for it to agree to accept liability itself.

Alternatively, it would need to prove after the event that the losses were external and beyond its reasonable control, perhaps by demonstrating an (unknown) level of robust due diligence.

But even applying the commission’s strict clarification, it may be possible for some liability to be alleviated by arranging for the assets to be held directly with a CSD, as opposed to the current model where assets are held at a CSD through a sub-custodian.

Divergence of opinions

Thorsten Gommel, a partner at PwC, says: “As the AIFM directive and Settlement Finality directive currently stands, a depositary bank that holds assets directly with the issuer CSD, for example a French securities with Euroclear France, the depositary bank is not subject to liability clauses.

"This is simply because AIFM directive Article 21(11) states – somewhat indiscriminately – that securities settlement systems are not considered delegates of a depositary bank, which is the precondition of liability for loss of assets in the custody chain.”

According to Gommel, “virtually all the big global custodians” have embarked on a strategy to increase the share of assets held directly with CSDs.

A recent report by PwC and Clearstream on T2S revealed that many custodians had started projects to analyse this scenario. There has been wide disagreement in the market in the past few months over what services the exemption covers but to Global Investor/ISF’s knowledge the commission has not informed market participants of its strict interpretation until now.

Christopher Stuart-Sinclair, a director in regulatory consulting at Deloitte, says: “There will no doubt be much debate still as to how some of the clauses of Article 21(11) should be interpreted, and specifically with regard to what exactly is the status of securities held through a CSD mechanism. There is a suggestion that by structuring holdings around the services offered by a CSD, that the reference to delegation extends in some way to liability for those holdings.”

Gommel agrees there is uncertainty. “There seems to be some confusion about Article 21(11) among both market participants and different regulators. Whereas some regard the exemption granted to SSSs as an institutional designation, others tend to see this applicable only for specific services of an SSS – that is, if it is really the last point in the custody chain.”

Tim Reucroft, director, investor services, Thomas Murray, takes the view that a CSD provides securities settlement services and not custody. “You do not delegate custody to a CSD, you delegate securities settlement. The global custodian cannot delegate the liability arising from custody – this is the whole point of the AIFM directive.”

Yet three senior-level market participants were “surprised” when they saw the commission’s emailed comment and one says this could be a “surprise legal turnaround”. Another says he wonders “why they put the clause in there if they consider it irrelevant”.

The commission’s narrow definition of securities settlement services has raised eyebrows. It says custody is not part of these services but, as one industry participant points out, the link is made in Preamble (42) of the directive: “Entrusting the custody of assets to the operator of a securities settlement system … should not be considered to be a delegation of custody functions.”

One interpretation of the Preamble is that if a depositary bank puts assets in custody at a CSD, it is not a delegation of custody and therefore the depositary bank is not liable. It must be noted that the preamble is not a legal document as such but rather explains the rationale behind the law and therefore is not legally binding.

Interestingly, the commission’s definition of securities settlement services comes from the proposed CSD regulation (CSDR) which is in the final stage of socalled trilogue involving the European Parliament, the European Commission and member states and is expected to be finalised before the European Parliament elections next May.

They are defined as the “core services” of CSDs in section A – notary service, central maintenance service and settlement service. CSDs also provide non-banking ancillary services but these are not classed under this section. Importantly, CSDR will replace the Settlement Finality directive, which is referred to as directive 98/26/EC in Article 21(11) of the AIFM directive, and its finished form could limit the services of a CSD that are exempt from delegation of custody.

Divide in the market

Aside from the commission’s views, there is a rift in the CSD community over whether depositary banks would be able to depend on the non-delegation clause where a securities settlement system (SSS) uses sub-custodians as its safekeeping agents.

One camp – which includes Euroclear – believes these agents are a necessary part of the CSD infrastructure and that depositary banks would not be liable for them.

Ilse Peeters, director in Euroclear’s public affairs division, says: “If a depositary bank deposits assets in an SSS it is not subject to the AIFM directive liability clauses regardless of the way the SSS holds the assets. As a market infrastructure, we are regulated more strictly than sub-custodians and also where we have indirect links, we are subject to very strict rules. The current debate centres around the functional way in which the market works but the proposed regulation is actually institutional.”

She says “many” of the ICSD’s links are direct links with other CSDs and that in “some cases” Euroclear Bank holds securities through sub-custodians to hold accounts at other CSDs.

A market participant who wishes not be named says he heard one individual say a sub-custodian of an ICSD with a large international custody business could theoretically circumvent all liabilities under the AIFM directive if it channels all its assets into an account at that ICSD and then takes them in a full circle by feeding them back into its existing commercial bank.

He says this is “complete nonsense from an economic and risk perspective just because you have simply touched the SSS and then everything behind that is in a big fog”.

PwC’s Gommel highlights the issues with commercial banking risk in CSDs. “Some risk managers see a slightly higher risk profile where CSDs act in fact as regional custodians and work with commercial banks to access other CSDs to hold assets.

Some industry participants believe that something has to change about this because – as with any other network – there is a risk of counterparty failure because there is a reliance on other commercial banks to hold the assets. It is probably not correct to say that all assets held with an SSS are equally safe.”

The opposing camp – which includes Euroclear’s biggest competitor Clearstream – believes depositary banks would be able to avoid liability only where the safekeeping chain exclusively contains infrastructure entities – where the chain does not include underlying sub-custodians because they are commercial banks.

Philip Brown, head of global client relations and member of the executive board at Clearstream, says: “We believe there are risks in our clients relying wholly on the non-delegation clause of AIFM directive, especially where an SSS uses sub-custodians as its safekeeping agents.

"The approach we have taken is, we believe, a prudent and logical one, which attempts to align us with what a court might rule in the event of a loss. We believe a judge would look very negatively on attempts to circumvent the spirit of the directive through the insertion of an SSS in a conventional agent bank custody chain.”

Indeed, as with any other network there is risk of counterparty failure because of the reliance on other commercial banks to hold assets, according to Gommel. “It is probably not correct to say that all assets held with an SSS are equally safe,” he adds.

Clearstream believes within its business the exemption would cover eurobonds because Clearstream is a securities depository for these assets, German assets because it is the CSD in Germany, or where it has direct links to CSDs in other countries.

BNY Mellon, which recently created an issuer CSD and aims to turn it into an investor CSD – which would enable it to link to other CSDs to do cross-border settlement – has not yet made up its mind.

“We are currently taking advice on what approach we should take so that we do the right thing,” says Chris Prior-Willeard, chief executive of BNY Mellon CSD.

Referring to the creation of the CSD, he says the option for depositary banks to reduce liability by holding a direct CSD account is “at the heart why we have done this”, although it must be noted that when the CSD was conceived the main motivation was Target2-Securities, and European Market Infrastructure Regulation (Emir) is also now important. http://bit.ly/187uBmr>

Aside from Article 21(11), some argue there is still a possibility for depositary banks to claim a loss of assets at a CSD is an “external” event while others are doubtful. Tim Reucroft says a depositary bank “can only delegate the liability arising from securities settlement at a CSD – because it is an external event”.

Deloitte’s Stuart-Sinclair says if fraud or bankruptcy occurred at a CSD, “it is unlikely that nice legal arguments” would sway the courts in favour of the depositary bank.

John Gubert, a consultant and former global head of HSBC Securities Services, is unsure. “The paradox is that the closer you are to a CSD, the less sure you can be that the regulators will actually agree that the depositary bank would not be liable for loss of assets. Nobody knows what the standard of care is. My assumption is where something happens within a CSD which is a management responsibility, it is definitely not within your control. If it is a policy matter, the question is: was that within your control?”

While the risk of a CSD losing assets is small, it carries a fat tail-risk because such an event could be catastrophic. As Gubert says: “There has never been a major loss at a CSD towards its participants but that does not mean there never will be.”



(Above: John Gubert, consultant and former global head of HSBC Securities Services)

Market needs an answer

Defining the role that CSDs occupy in the post AIFM directive world is paramount to the protection of investors. Both the European Commission or the European Securities and Markets Authority (Esma) declined to tell Global Investor/ISF the reasons for including the SSS exemption in the first place.

Some market participants say legislators believed CSDs were safe infrastructures while others say it was deemed impossible for depositary banks to do due diligence on these huge entities.

While Esma declined to be interviewed for this article, a spokesman said: “We are aware of this issue and are considering how to take this forward.”

The commission had not responded to further questions about Article 21(11) by the time this article had gone to press.

In an interesting twist, Global Investor/ ISF understands German regulator BaFin held a meeting with the top 10 players, industry associations, audit firms and law firms on November 27 regarding interpretation of the AIFM directive in the context of German legislation and updating a circular on depositary banks, and that one of the agenda points was whether the SSS exemption should apply only where the SSS is the last point in the custody chain.

Regardless of which interpretation of Article 21(11) is correct, and who or what is to blame, it is clear there has been breakdown of communication between law makers, regulators and the market.

There have been calls for a legal opinion or guidelines to be issued on the matter, urgently, considering the legal text has been or is currently being transposed into national law in member states and many AIFMs must be compliant by July 2014.

Stuart-Sinclair says: “At the moment it is up to the market to come up with its best guess. It is a rather sad situation to be in after so many years of debate, consultation and effort.

“Unintentionally perhaps, this seemingly innocuous insertion may prove a test for how law, regulators and European institutions will operate in financial markets going forward. One thing is certain, the issue is a pressing one.”

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