New European Union (EU) regulations on fund depositaries threaten to make some emerging market investments prohibitive for managers, despite experts’ efforts to lobby the EU on the issue in May.
As they stand, post-crisis initiatives such as Ucits V and the Alternative Investment Fund Managers (AIFM) directive would force depositaries and custodian banks to take on strict liability for the assets they hold on behalf of fund managers.
The measures are designed to ensure depositaries are held responsible if they accept fake assets on behalf of fraudulent investors such as Bernard Madoff, which would lower the risk of fund fraud altogether. However, they would probably make it extremely expensive or even impossible for depositaries to take custody of certain emerging market instruments.
This latest wave of depositary regulation began with the AIFM directive, which was first published in April 2009. Although it seems inevitable the directive will be passed, regulators still have to draft many of the lower-tier rules, including those on depositary liability.
”It might not be possible for depositary banks to offer custody services in some emerging markets as the risk of liability realising would be too great”
As the proposals stand, depositary banks will face severe penalties under the AIFM directive and Ucits V if they lose assets deposited with them. This regulation applies, for example, if even a sub-custodian goes bankrupt.
Jarkko Syyrilä, the deputy director general of the European Fund and Asset Management Association, says depositary banks face a “huge liability” under the new rules. This may be particularly difficult for emerging markets funds. “It might not be possible for depositary banks to offer custody services at all in some emerging markets as the risk of liability realising would be too great,” Syyrilä says.
Depositary banks would have to raise their capital requirements or insure themselves against the added risks. So far, they have not determined what this will mean for their fees. (article continues below)
Yet if the primary custodian is taking all the responsibility for sub-custodians, it seems only natural that they would charge for taking on this risk.
“We have no idea what this is going to mean for custody fees but it is likely to be very costly,” says Syyrilä. So far, he says, providing depositary or custodial services has been a low-margin business, but the question is now whether banks would want to offer this service at all for some instruments.
Many asset managers fear that the new regime will translate into higher depositary fees, which would increase their cost of running funds.
But Adam Fairhead, the global head of product development at HSBC Global Asset Management, estimates that changes will increase only marginally. He says the cost of custody largely depends on the custody model that groups use. Although this cost may rise, Fairhead says the increase will be limited.
Syyrilä, on the other hand, fears that fees will increase significantly and, along with other regulatory measures, push up the cost of funds. He predicts funds will become more expensive as asset managers will have to raise the total expense ratio for their products.
Toby Hogbin, the head of product development at Martin Currie, which offers several emerging market products, says asset managers do not have the capacity to deal with the costs associated with the new regulations.
“Inevitably, asset managers will have to pass on this cost to their investors,” Hogbin says. “Regulation always comes with costs.”
Hogbin says the immediate consequences of implementing Ucits IV, for example, will already be costly for asset managers, but the impact of Ucits V is going to increase costs even further.
Changes to the custodian agreements will be just one of the price drivers for funds.
Amanda Rowland, the leader for asset management regulatory at PricewaterhouseCoopers, says investment houses will have to base their pricing mechanics on this and other requirements in the latest directives. In addition, they will have to review the countries they can market their funds in and which investors they can target.
The directive may indeed limit investor choice by reducing numbers or locations of funds. Rowland says the directive will “add another level in the complex web of considerations for asset managers” in deciding whether particular jurisdictions are too risky or costly.
But as much of the lower-tier regulation is still at the draft stage, Rowland observes that lobbyists for the asset management industry and politicians will have time to propose changes, giving them an opportunity to mould the eventual form of the regulation to suit their industry.
The European Commission was unavailable for comment.