ESMA pressed to abandon strict sub-custody segregation

ESMA pressed to abandon strict sub-custody segregation

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The European Securities and Markets Authority (ESMA) has been strongly urged to abandon the strict interpretation of the segregation of client assets throughout the custody chain, at the Global Custody Forum in London today.

The introduction of the Alternative Investment Fund Managers Directive (AIFMD) and the UCITS V Directive, introduced in July 2014 and March 2016 respectively, left open the interpretation of the segregation of client assets.  

“The first thing that comes to mind is the open point on AIFMD and UCITS V,” said James Farrugia, partner at Ganado Advocates. “Do we need to segregate AIF assets, UCITS assets and assets belonging to other clients all the way down the custody chain or not?”

While it has been decided by ESMA, and accepted by the industry, that assets must be segregated into UCITS, AIF or other investor groups at the client-facing depositary level – which is liable for assets – it remains undecided whether this must be maintained at non-client-facing levels of sub-custody below the depositary.

The asset segregation regime is designed to ensure that the ownership of assets is clearly identifiable and robustly protected in the event of an insolvency. ESMA is considering the responses to its consultation, which closed in September, ahead of submitting its re-drafted technical standards to the European Commission.

The panellists welcomed the notion that ESMA, which unusually consulted twice on the issue, has demonstrated “a bit of backtracking”.

“If EMSA adopts a hard position, it is because it does not recognise the distinction between segregation and omnibus structure,” said Farrugia. He added that the regulatory institution “seems to be unable how these two principles can work together on the level of protection for the assets”.

The panel, and seemingly a majority of the delegates, was in agreement that asset segregation according to investment vehicle type beyond the client-facing depositary bank does not serve a purpose except to increase risk of error. “If we had segregation down the chain in UCITS assets, for example, I think it would only create more operational risk,” commented Farrugia.

Farrugia noted that clients might need separate accounts for tax reclaim purposes but segregating them just for the sake of having “different buckets all the way down the custody chain” is “useless”.

Susan Wright, regulatory and compliance specialist at the Investment Association, was in agreement: “I can’t see at the moment why there would be any benefit to introduce further risk,” she said.

“At the end of the day, the entity which needs to maintain proper records of the ownership of those assets is the custodian or depositary that is facing the client,” said Farrugia. “The custodian needs to do their job and ensure their contracts are robust.”

“There is a clear obligation under AIFMD and UCITS V that the depositary facing the client must be satisfied and undertake extensive due diligence,” Farrugia added.

Moderator Habib Motani, partner at Clifford Chance, added that the issue was not the segregation of client assets from those of the custodian, “that is a given”, but whether it is beneficial to segregate at all levels of sub-custody in terms of vehicle type.

“Once you have a segregated block, whether you divide that block into three individual segregated blocks or leave it as one block, it makes zero difference to the protection element,” said Motani. “It does no such thing apart from add cost and operational issues.”

Non-financial regulations

In addition to the concern regarding segregation, the Investment Association’s Wright added non-financial regulations were quite “tricky” for custodians and the IA’s asset manager membership.

“The General Data Protection Regulation (GPRP) for example will impact financial services and custodians in a huge way,” said Wright. “But from a custodian’s point of view, this will provide a good opportunity to work with asset managers, particularly if they are only based in one jurisdiction.”

“I think asset managers are going to rely more and more on their custodians. In some, but not all cases, custodians are now doing what they should have been doing in terms of liabilities, responsibilities and who does what."

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