On 29 May 2018, the European Commission (the “Commission”) proposed legislative changes to the safekeeping duties of depositaries under the UCITS regime and AIFMD. These proposed changes follow an opinion by the European Securities and Markets Authority (“ESMA”) on asset segregation in July 2017 where ESMA asked the Commission to clarify certain obligations of the depositary.
The Commission’s aim is a set of common rules to ensure protection of assets safe-kept by depositaries or custodians for their clients across member states. Currently, national competent authorities and market participants apply the regulations inconsistently.
The European Commission Proposal
A summary of the changes proposed by the Commission is detailed below.
The proposed changes establish the factors that determine how frequently the financial securities accounts and internal records of the depositary and of the third parties (i.e. custodians or prime brokers acting as sub-custodians) to which safe-keeping functions have been delegated should be reconciled. The trading frequency of the depositary client in question and the trades carried out by other clients whose assets are held in the same omnibus account will impact on the frequency of reconciliation.
The depositary will need to maintain a record in any financial instruments account opened in the name of an AIF or UCITS client showing that the assets being kept in custody by a third party belong to that particular client. In summary, where custody functions are delegated, the depositary will need to maintain a segregated account in the name of the AIF/UCITS.
Depositary and Appointed Third-Party Contract
It is proposed to specify the minimum details that should be included in a contract between a depositary and a third party upon delegation of custody of assets. The contract should guarantee the depositary adequate access to information and an ability to inspect records.
The depositary must be able to identify all entities in the custody chain and also be able to verify the quantity of identified financial instruments which the third party is keeping in custody.
Should the custody function be sub-delegated, the third party will have to contractually secure rights from the sub-delegate which are equivalent to those which it had, itself, granted to the depositary.
Minimal Asset Segregation Requirements at Delegates
The Commission has clarified that a third party custodian to which the safe-keeping function has been delegated can hold assets of UCITS/AIF clients and other clients of one depositary in the same comingled omnibus account provided that the third party’s own assets and assets belonging to other clients of the third party are held in separate accounts. In summary, custodians can use omnibus accounts to hold the assets of one depositary client only.
In addition, the third party delegate will be required to issue the depositary with a statement detailing the assets of the depositary’s AIF or UCITS clients to ensure increased asset protection and to enable the depositary to comply with its oversight obligations. This statement should be issued both on a regular basis and whenever a change in circumstances occurs.
AIFMD: New Obligations for Delegation outside the EU
The Commission proposes to introduce new obligations for depositaries which delegate the custody of assets to a third party located outside the EU. In such a case, the depositary would be required to obtain legal advice from an independent source confirming the insolvency laws of the third country.
The depositary would also have to ensure that the third party complies with its national laws securing the benefits of asset segregation and communicates any changes to the applicable insolvency law and its effective application to the depositary.
The consultation period for the draft legislation ended on 26 June 2018. The Commission will now finalise the proposed changes and hand the matter over to the European Council and European Parliament for input.
Potential Impact of the Proposal on the Custody Industry
The Commission’s proposals have come as a surprise to the custody industry. As a result of the Commission’s proposals, custodians will likely have to reorganise their structures and operate multiple omnibus accounts for each of their depositary clients. This could impact the willingness of custodians to take on delegated work from smaller depositaries and could result in more assets being pushed to the larger depositary providers.
In addition, new technologies will likely play a bigger role in the increased frequency of reconciliation of accounts by depositaries.
Download your copy of Proposed Changes to Asset Segregation Rules
KB Associates’ Services
KB Associates offers a range of services to investment funds and management companies including:
- The provision of UCITS/AIF management company services.
- The provision of designated persons to perform UCITS business plan and AIFMD programme of activity managerial functions.
- The provision of UCITS/AIF operational support.
If you would like to discuss any issues raised in this article or related to KB Associates’ services in general, please feel free to contact Mike Kirby (+353 1 667 1980), Peter Northcott (+44 203 170 8813) or Mike Parton (+1 345 946 4224).