Will depositary liability extend to CSDs under AIFMD after the arrival of T2S?

As the Directives are written, one of the main differences between AIFMD (the Alternative Investment Fund Managers Directive) and the current text of UCTIS V is the extension of depositary liability, under the latter, down to the market level and CSDs (central securities depositories). AIFMD, at least currently, provides for depositary liability down to sub-custodian level only, it does not extend to CSDs, whereas UCITS V seeks to extend this to CSDs.

The European Central Bank’s Target2-Securities (T2S) single-settlement platform for Europe, which is going to go live in four Waves starting on 22 June 2015 makes a distinction between Issuer CSDs and Investor CSDs, although this distinction is not present in the current CSD Regulation. One of the objectives of T2S is to create competition amongst European CSDs and it does this on two fronts: firstly amongst issuers who should be free to select any T2S CSD and, secondly, amongst investors who will be free to select any T2S CSD (the difference between the ‘should’ and the ‘will’ reflects local legislation). Obviously the depositary is not responsible for the Issuer CSD – this is the choice of the issuer, but the depositary is responsible for the choice of investor CSD – it could be Monte Titoli, or Cleastream Banking Frankurt (or BNY Mellon or globeSettle) or it could be Estonia or Latvia. So if it is the depositary’s choice, should it then be liable for that decision, just as it is liable for its selection of sub-custodian banks?

At present, there is no choice over settlement or use of local market FMIs (financial market infrastructures). Under AIFMD, depositary banks need to make their fund clients aware of country risk – namely risks inherent in the markets into which they are investing via things such as political volatility, propensity to natural disaster and the robustness of that country’s FMI.

With choice, however, comes the option to move settlement away from that country’s FMI to a single access point to the T2S platform. Will this then, extend the liability of depositary banks under AIFMD as far as CSDs? If they are choosing them, will they be liable for them?

This would only affect the liability as regards CSDs that have signed up to T2S. Thus it would exclude investments in the UK and outside of Europe.

“Will there be a liability for CSDs under AIFMD? The approach from ESMA to both AIFMD and UCITS V is the same,” commented one panellist at the recent Luxembourg Depositary Conference. “This would make the depositary liable for CSDs under both directives.”

As UCITS is designed to provide for investor protection in the retail space, the increased liability at the CSD level makes sense. As we have written previously, http://ds.thomasmurray.com/opinion/ucits-v-turns-pressure-banks, one of the unintended consequences of AIFMD has been the emergence of custodians, such as BNY Mellon, establishing CSDs so as to minimise exposure to third parties under that Directive. It is a way of keeping liability in-house and, therefore, under the bank’s direct control. 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, as far as possible, to keep as much of the liability in-house. With the advent of T2S in the CSD space, there will almost inevitably be the exit of some domestic market CSDs.

Yet the impact of T2S upon the oversight of the alternatives world is set to run farther still. Aside from custodians moving into the CSD space, on the T2S platform, the first Wave of which is set to go live on 22 June 2015, depositaries will have to make a choice as to which investor CSD they deposit client assets. The Bank of Greece Securities Settlement System, Monte Titoli, Malta Stock Exchange, Depozitarul Central S.A and SIS SIX Ltd are the five set to go live on T2S next year and this is, perhaps, one area of first mover advantage for these CSDs in T2S Wave 1.

Under the current CSD structure in Europe, there is no choice – you simply use the CSD that exists in the jurisdiction of the fund’s investment.

This will not impact issuer CSDs, since they are selected for the issuance of securities and bonds to the market. These will still largely be chosen according to local market expertise, i.e. the local market CSD would likely be selected for issuer services into that market, with Euroclear and Clearstream holding virtually all Eurobonds, for example.

With investor CSDs on the T2S platform, however, the depositary bank, responsible for safekeeping of a fund’s assets, will have to choose a CSD at which to keep the securities and bonds of its underlying fund clients. In the same way that the depositary has to monitor and assume strict liability for fund assets through its counterparty network – from custodians and sub-custodians to prime brokers – the depositary will have to further monitor, and assume liability for, the CSD that it has selected under UCITS V, as it stands.

This creates further problems for local market CSDs on the T2S platform. In the move to competition in the CSD space in Europe, these will likely be the losers. “Monopolistic, national CSDs will be losers in the new-look CSD space,” says Henri Bergstrom, director of new markets at NASDAQ OMX. “They will either get bought out, or their role will diminish.

“The custodians will also be losers as a change of roles is occurring where the CSDs will take on a big role on the collateral management side. Safekeeping of collateral will move to the CSDs.” It is, therefore, a prudent move on behalf of BNY Mellon to enter the CSD space. They can act as custodian and as CSD, thus keeping and expanding their collateral management and safekeeping business. The issue here is that ESMA states that CCPs must hold their collateral at CSDs, not at custodian banks – so it is perfectly logical for custodian banks to turn themselves into CSDs. There is also the advantage that a central collateral management hub will also make it easier for market participants to move their collateral around.

With depositary banks having to greatly increase their monitoring and due diligence, it will be important that they work with, or are exposed to, risk from entities that they trust. This was a rumoured problem at the outset of AIFMD with prime brokers; that some funds may have to switch their prime brokerage service providers to other companies at the behest of their depositary bank. Every fund needs to appoint a depositary in order to be AIFMD compliant, so the depositary can have a big say in the choice of counterparties.

With the depositaries having a choice of investor CSD with the advent of T2S, depositaries without a global custodian will be looking for a single access point to the platform and will choose those companies that they trust. If a depositary bank is already monitoring and working closely with BNY Mellon, for example, on the custody side of AIFMD, would it not make sense for it to utilise BNY Mellon’s CSD services too? There must be every incentive to come to such an arrangement in order to reduce a depositary bank’s monitoring obligation.

Further to the likelihood of T2S linking depositary liability under AIFMD and UCITS V, the approach of ESMA (European Securities and Markets Authority) to both directives will also have an impact in this regard. “Will there be a liability for CSDs under AIFMD? The approach from ESMA to both AIFMD and UCITS V is the same,” commented one panellist at the recent Luxembourg Depositary Conference. “This would make the depositary liable for CSDs under both directives.”

There is set to be a review of AIFMD’s impact by ESMA in 2018. This will be one year after the fourth, and final, Wave 4 of T2S implementation on 6 February 2017 and could prove to be a good juncture at which to provide clarification around depositary bank liability for investor CSDs under AIFMD.

“All of the contracts that we have seen have a clause in them stating that the CSD is not a sub-custodian and, therefore, the depositary is not liable for it,” said a lawyer that we spoke to about the subject. “UCITS V, however, is altering this and depositaries are having to evaluate CSDs for permanent custody. I have been expecting some movement towards this liability, as found under UCITS, and the increased harmonisation of UCITS and AIFMD.”

Given that harmonisation is something of a buzzword in Europe, it would be no great surprise if the structures of liability under both UCITS V and AIFMD were to become more strongly aligned. It would also remove the possibility for arbitrage across the two directives.

Given this, and the freedom choice that will be bestowed upon settlement within Europe, it would be no surprise were depositaries to find they are liable for CSDs in Europe under AIFMD.

Tags: AIFMDUCITS VT2SDepositariesDepositary liabilityRegulationCSD