UCITS V turns up the pressure on banks

One of the key elements of the recently approved UCITS V directive is its extension of depositary bank liability down to the central securities depository (CSD) level. It is one of the key differences in depositary liability from the Alternative Investment Fund Managers Directive (AIFMD), as regulators look to further strengthen the oversight of the alternatives industry.

One of the unintended consequences of AIFMD was the emergence of custodians, such as BNY Mellon, establishing CSDs so as to avoid third party liability under that Directive. It is a way of keeping liability in-house. UCITS V was supposed to close this regulatory loophole, but instead is set only to reaffirm it.

In extending depositary liability down to the CSD level, it makes sense - even more so - for the banks to try and keep all of their liabilities under the one roof. With the advent of Target2-Securities (T2S) in the CSD space, there will almost inevitably be the exit of some domestic market CSDs. If there are any losses in the transition of the book-entry records to another CSD which impacts the underlying securities in a UCITS, it is now expected that the depositary bank will be liable for that. Is this a fair and level playing field when CSDs and custodians in Europe are imminently entering a period of unrivalled competition?

With increased pressure to innovate being placed upon CSDs by T2S, many will try to move up the value chain to compete with custodian banks. This will inevitably take them into uncharted service areas which may increase their risk profiles, particularly those that take on banking ancillary services. However, at least for the underlying assets of UCITS funds, these risks have been passed on, via UCITS V, to the banks – those with the deepest pockets. “The aim of European regulation has been to enforce stability, standardisation and responsibility,” says Jim Micklethwaite, director, capital markets at Thomas Murray Data Services. “Yet T2S is driving market infrastructures into a competitive world – it is creating instability in the utilities that performed so well during the financial crisis. The European Commission wants low risk and competition, and these generally don’t follow hand-in-hand. One only has to look at the fragmentation in both the trading and clearing space in Europe to see that transparency and risk control are in opposition to gaining a competitive edge”.  

It is not only the CSDs that are being caught in a commercial and regulatory crosswind, the banks are also experiencing an extremely difficult time, says Jim. “They are facing revenue pressure from decreasing margins, huge costs of regulatory compliance and are about to incur more capital and liquidity costs from Basel III. For the many servicing AIFs and UCITS vehicles they will also be expected to pick up all of this extended liability, but there does not appear to be a proper capital framework around this because it is classed as operational risk and is thus unquantifiable in their models without precedents. There needs to be a proper framework in place so that they can haircut this business.”

UCITS V is a further complication of the relationship between the banks and market infrastructure with the complication being one underwriting the other at a time when they are being brought into competition. With banks becoming CSDs and some CSDs likely to become banks, and quite possibly depositary banks, it may not be black and white in the future as to who is bailing out whom.

Tags: UCITS VAIFMDbanksRegulationT2SCSD