Segregation of assets an area that needs clarifying under AIFMD

Segregation is a hot topic under the Alternative Investment Fund Managers Directive (AIFMD). Alongside the depositaries taking on overarching liability for all losses incurred in their network of sub-custodians (including collateral agents, prime brokers and transfer agents), as well as oversight, record-keeping and cash monitoring duties; they must also ensure that all assets under custody are segregated at a sub-custodian level.

The Directive had originally pencilled in segregated accounts at prime broker level, too, as they are considered as sub-custodians, but this was met by strong opposition in the prime broker community. It is believed that regulators, at a national level, are softening to this and that the prime brokers may get to continue holding assets along existing business model lines, with increased reporting.

The topic of segregation was discussed at the recent Thomas Murray Data Services webinar: Why firms need to be concerned with AIFMD right now. “Under AIFMD there is no requirement for segregation at the market level; it stops at the sub-custodian level,” said Roger Fishwick, director and chief risk officer at Thomas Murray. “What happens thereafter is up to the sub-custodian. The AIF must have an account with a depositary and the safekeeping is then the responsibility of the depositary.”

In the chain from global custodian, to sub-custodian, to central securities depository (CSD) and market level, segregation under AIFMD is only required at the sub-custodian level. The level of segregation then depends upon the CSD and market. This will, though, increase the push towards segregated accounts or sub-accounts at CSD level, since the depositary will want a clear line of sight of where an AIF’s assets are if it is assuming strict liability for losses.

“Segregation works at an operational level, but there has been a lot of discussion around best practice and what actually offers the best protection,” commented Richard Frase, a partner at law firm Dechert. “From an AIFM’s perspective, segregation at the CSD level entails additional cost and operational issues which come into the equation alongside availability of a model and the level of protection.”

From the perspective of the depositary, this is still an area that needs clarification, a point raised by Shane Ralph, head of depositary oversight services – EMEA, at State Street. “I expect the European Securities and Markets Authority (ESMA) to step into this area over the next couple of years to expand upon what the requirements actually are and bring some clarity. At the moment, there are a lot of different views as to what is required. From the depositary bank perspective, it will be interesting to see how the regulators across the Member States expect us to segregate.”

Under UCITS V it appears that the current draft provides for the depositary to be responsible for assets of the fund down to market (CSD) level, which, with CSD Regulation (CSDR), will provide further drivers for segregation at the market level. CSDR only states that CSDs have to offer individual segregation – it does not state that it has to be priced competitively to encourage its use, nor is to be made mandatory. For depositaries taking on increased liabilities, however, individual segregation will be an appealing selling point.

The main driver behind AIFMD is investor protection and that is what account segregation delivers, said Fishwick. “From the investor’s perspective it is about being able to identify your assets throughout the chain. Investors might have segregated accounts at global custodian level, but if the go into an omnibus account at the sub-custodian level you lose sight of them. Also, segregation delivers two sets of records – if there is an issue at the global custodian, investors will also have the sub-custodian records of their assets.”

Richard Frase concurred. “You need to be able to identify your assets in case of a Lehman style situation. The purpose of all of this is to put in place a robust framework whereby your assets can be identified. In developed markets, this will enable claimants to assert some sort of proprietary claim over their assets in the case of insolvency.”

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