AIFMD Depositary - Developing an Operating Model

AIFMD Depositary:

Developing an

operating model

A white paper co-authored by Shane Brett of Global

Perspectives and Alan Meaney of Fund Recs

www.fundrecs.com | AIFMD Depositary: Developing an operating model | www.globalperspectives.co.uk

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Table of contents

Introduction .............................................................................................. 3

Depositary Lite vs Full Depositary .............................................................. 4

Depositary Functions ................................................................................ 6

Safe Keeping of Assets .............................................................................. 7

Oversight of the Fund................................................................................ 9

Cash Flow Monitoring ............................................................................. 11

Conclusions ............................................................................................. 13

Meet the authors .................................................................................... 14


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Introduction

This whitepaper is co-authored by Shane Brett, Managing Director at Global Perspectives, an

Asset Management and Hedge Fund consultancy and Alan Meaney, Director at Fund Recs, a

specialist software provider to the Funds Industry.

During the past six months Shane and Alan have held discussions with 30+ depositary firms

around their plans for implementing AIFMD and how their framework for day to day activities

might look.

This document covers AIFMD from the perspective of a depositary and discusses some of the

practicalities in setting up an operating model in order to comply with the directive on a day to

day basis.

The information contained in this whitepaper is general in nature and should not be taken as

specific guidance for setting up an operating model.

AIFMD requires the depositary to take on strict liability for loss of assets held in custody and

even if this responsibility is discharged there is still substantial risk to the depositary.

Therefore, it is imperative that any firm looking for guidance on this matter seeks advice from

their local legal counsel when finalising their model.

The aim of this document is to provide a useful starting point to generate some of the internal

debate and questions when transitioning from discussing the Directive to implementing

processes and procedures around its compliance.

This is intended to be a working document and we plan to update it as new information on

depositary operating models becomes available.

We hope you find this document useful and appreciate any feedback you might have.

Regards,

Alan and Shane


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Depositary Lite vs Full Depositary

The role of the depositary breaks down into three areas defined under Article 21(7), (8), and (9)

of the Directive; the safekeeping of assets held in custody; monitoring of cash flows and an

oversight role.

Full Depositary

Only EU AIFM managing EU AIF’s are subject to the full depositary regime (Article 21), whereby

a single depositary is required to perform the three core depositary duties of safe keeping of

assets, cash flow monitoring and oversight.

Under this model, the depositary is required to take on strict liability for loss of financial

instruments.

However, a depositary may delegate the safekeeping of assets to sub-custodians, but may not

delegate the cash monitoring or oversight duties.

Depositary lite

“Depositary lite” is the term used to describe the obligations of a depositary appointed to a

non-EU AIF managed by an EU AIFM which markets in Europe under a private placement

regime under Article 36 of the Directive.

The obligations of a depositary lite are similar to those applied to a full depositary with a few

key differences.

The liability standard for the loss of the AIF’s assets in custody is negligence rather than the

strict liability standard.

It is possible for different entities to undertake the different depositary lite tasks; therefore, a

prime broker could be responsible for safekeeping (assuming it had segregated the depositary

function from the prime broker one), an administrator for cash monitoring and a supervising

entity for oversight.


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Strict liability

Under AIFMD the depositary remains liable for the loss of any of the AIF’s assets held in custody

unless it can prove that the loss has arisen as a result of an external event beyond its

reasonable control, the consequences of which would have been unavoidable despite all

reasonable efforts to the contrary.

This effectively makes the depositary strictly liable for the loss of assets in custody, which is a

significantly higher standard than the one depositary firms are used to.

The pre-AIFMD standard of liability contractually assumed by depositaries did not extend to

loss of assets by their agents or sub-custodians, except where they breached their legal

standard of care in the selection, appointment and monitoring of such agents or sub-

custodians.

This contrasts to the AIFMD position where, in the absence of force majeure events, a discharge

of liability, or a safe harbour for assets held through a central securities depositary, a depositary

is strictly liable for loss of assets in custody by any party beneath them in the chain of custody.

This includes all sub-custodial agents and prime brokers (and their own independent sub-

custody networks).

Full Depositary (EEA AIF)

Cash flow monitoring

Asset safekeeping

Oversight

Single Entity

Strict Liability

Not AIFM

Not Prime Broker

Delegation Restrictions

Location Requirements

Depositary ‘Lite’ (non EEA AIF)

Cash flow monitoring

Asset safekeeping

Oversight

× Single Entity

× Strict Liability

× Not AIFM

× Not Prime Broker

× Delegation Restrictions

× Location Requirements


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Depositary Functions

Under AIFMD the depositary has three key functions which must be executed. These are the:-

Safekeeping of Assets

Oversight of the Fund

Cash Flow Monitoring

We will look at each of these requirements in turn, as well as identifying some of the key

considerations for depositaries in developing their operational model.

AIFM


Article 21 (7)


Article 21 (8)

In Custody Assets

Article 21 (8)(a)

Other Assets

Article 21 (8)(b)

Oversight

Article 21 (9)

Depositary


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Requirements under AIFMD:-

Under the AIFMD the depositary must maintain either custody or recordkeeping for all

the assets on the fund.

The funds’ assets must be properly segregated on the depositary’s books or on the

books of its delegates (e.g. sub custodians)

The depositary is required to monitor the custody risk throughout the chain of custody

on an on-going basis.

All assets of the fund which cannot be held in custody by virtue of their nature (e.g.

investments in other Collective Investment Schemes) must be recorded and monitored

by the depositary.

The assets of the fund must be separated from the assets of the depositary in such a

way that they can be clearly identified as belonging to the fund at all times.


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Operational Considerations

There is still some debate regarding the level of segregation required under AIFMD.

Many depositaries feel it is extremely difficult to implement the segregation

requirements of AIFMD in practice. We would recommend a “best efforts” basis be put

in place for all funds and their assets.

Implementing this separation of assets is likely to increase the cost of the depositaries

operational model, as they put in place the required financial, operational and

technological enhancements required to comply with the segregation rules.

It is still unclear how many national regulators view managing conflicts of interest -

where the same large organisation could be providing depositary, custody and

administration services (“One-Stop Shop” model) to an AIFM. Depositaries would be

advised to ensure their depositary model is developed as a clearly separate function

with its own processes, controls and reconciliation functions.

Depositaries need to consider how they will best mitigate risk in their operating model if

one of their prime brokers proves unable to perform the custody function on behalf of

the fund (for example in the return of the funds’ assets). Enhanced and on-going prime

broker monitoring and due diligence will be required.

In completing their prime broker due diligence depositaries need to ensure they are

comfortable with the operational model and controls the prime broker has in place.

Where these models do not match the depositaries risk profile, the depositary may not

wish to have the prime broker appointed. This could lead to a conflict with the fund

manager and their investment strategy.

Operationally depositaries need to consider carefully how prime brokers and sub-

custody delegates outside the EU will be managed. Local laws (for example in the US)

could be different (or even conflict) with the requirements of European regulation.


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Oversight of the Fund

Requirements under AIFMD

Under the AIFMD the depositary must maintain oversight of the Fund.

This includes:-

o Ensuring that the NAV is calculated in accordance with the rules of the fund and

the valuation principles within the AIFMD.

o Ensuring that the sale, issue, repurchase, redemption and cancellation of units or

shares of the AIF are carried out, and that the AIF’s income is applied, in

accordance with the relevant national law and the rules of the AIF;

o Ensuring that all transactions involving the AIF’s assets, any consideration is

remitted to the AIF within the usual time limits.

The depositary must also monitor the investments of the fund to ensure they are in

accordance with its stated investment restrictions.

The depositary must maintain accurate records in relation to all its oversight

responsibilities.

The depositary cannot delegate any of these oversight responsibilities to a third party.


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Operational Considerations

The depositary should be aiming to “plug-in” to the existing service providers on the

fund.

However depositaries will be heavily dependent on reports and data feeds from the

fund accounting, valuation and transfer agency departments of the fund’s

administrator. These linkages will need to be carefully controlled and fully tested.

In cases where the administration of the fund is done by a third party, additional

resources will be required to build and test the protocols and controls put in place to

ensure the depositary can access the fund data it needs to execute its oversight

requirements on a timely basis.

Under the depositary-lite model it is likely to be Prime Brokers who will typically

perform the safe keeping of the funds’ assets. This means depositaries have to move to

establish data and reporting linkages between these third party firms and the

depositaries own systems.

Substantial operational training will be required at most depositaries, as well as the

introduction of new controls and systems, as depositaries seek to interpret the practical

implementation of the AIFMD rules.


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Requirements under AIFMD

AIFMD requires that the depositary monitor the AIF’s cash accounts and completes a

reconciliation of the AIF’s cash flows.

The depositary has a responsibility to put in place effective procedures to reconcile all

the movements of cash on the fund on a daily basis (or as so often as they occur in a

more illiquid fund).

This includes implementing and completing a full reconciliation and overview of the

funds cash positions and cash movements, including subscription, redemptions, income

etc.

The depositary must be able to identify any unusual or unexplained cash flows at the

close of each day.

Where discrepancies are identified and are not resolved without undue delay, the

depositary must immediately move to notify the AIFM.

The depositary must be able to reconcile its own records with that of the AIFM.


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Operational considerations

In order to insure a full overview of transactions the depositary must have access to all

of the cash accounts of the AIF and receive statements in a timely manner for accounts

it cannot access reports for directly (i.e. T+1)

It is important to note that unreconciled fund accounting cash transaction reports will

not provide sufficient comfort as to a true reflection of the actual underlying cash

transactions on the fund. Using data from the broker/custodian side for cash flow

monitoring is a prudent approach.

For different AIF’s the definition of ‘unusual or unexplained cash flows’ will vary.

Therefore it is difficult to establish a single set of rules for cash flow monitoring that can

be applied to all funds. One approach is to agree applicable rules in advance on a fund

by fund basis with each AIFM. Although this adds additional complexity there seems to

be no alternative.

Procedures for dealing with cash exceptions must be established and signed off with

each AIFM. The time to document these is now and not when a breach occurs.


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Conclusions

As can be seen from this white paper the development and implementation of a

comprehensive depositary model involves many important operational considerations.

The end of the transition period for AIFMD implementation increases the urgency for which

these issues must be analysed and addressed.

Depositaries would be well advised to seek expert independent guidance regarding the rollout

and implementation of their depositary models, as depositaries adopt these new functions and

the industry moves to a new standard.

In implementing their new operational model depositaries will require a comprehensive suite of

software to enable them to properly execute their safekeeping, oversight and cash-flow

monitoring obligations.


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Meet the authors

Shane Brett, Managing Director - Global Perspectives

Shane Brett is a consultant, author and thought-leader specialising in

hedge funds, asset management and the wider global economy.

He has worked in the Alternative Investment and Financial Services

industry for 18 years and has managed large operational teams for hedge

funds and their administrators including UBS & BNP Paribas, product

development for Northern Trust and HSBC, as well as Global Operational

Due Diligence Programs for RBS Asset Management (now Aberdeen AM).

In 2011 he founded "Global Perspectives" - the hedge fund and asset management advisory and

research consultancy.

Shane is the author of two books - “The Future of Hedge Funds” (2012) & “The AIFMD Cheat

Sheet” (2013).

Shane is a member of the Editorial Board of “All About Alpha”, a Contributor Writer for Seeking

Alpha, as well as publishing extensively in the Investment industry (e.g. HFM Week, All About

Alpha, Hedge Fund Insight and Hedge Fund Journal).

Shane holds an MBA in Management Consulting from the University of Wales and project

management qualifications in PRINCE2 and Six Sigma.

Contact: [email protected]

Phone: +353 (0) 87 115 2173

About Global Perspectives

Global Perspectives provide bespoke economic, asset

management and hedge fund research, consulting and advisory

services to the fund managers and administrators worldwide.

Our monthly White Papers on all aspects of the asset

management industry and the wider global economy are

following closely and widely cited in the asset management and hedge fund community.

mailto:[email protected]


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Alan Meaney, Director – Fund Recs

Alan brings over 9 years’ experience in the Fund Administration Industry

and studied Business Information Studies at Dublin Institute of

Technology.

Alan started his Funds Industry career at HSBC and more recently worked

in Fund Accounting at SEI Investments.

Alan founded Fund Recs in 2013 with Padraig O’Scanaill. Alan has written several industry

related articles including ‘Working with CSV files’ and ‘Six Steps to Automating Your

Reconciliation Workflow’.

In early 2014 Alan graduated from the Enterprise Ireland Hothouse New Frontiers entrepreneur

development programme.

Alan has taken the insights and pain of doing manual reconciliation's over the years and used

his technical knowledge to produce the Fund Recs solution.

Contact: [email protected]

Phone: +353 (0) 87 767 8844

About Fund Recs

FundRecs.com provides cloud based reconciliation

software for the Funds Industry.

Recently it launched its Depositary Rec product which

helps depositaries scale their services.

It includes modules for cash flow monitoring, custody record keeping and cash reconciliation.

Based in Dublin, FundRecs.com was established in 2013 and is supported by Enterprise Ireland.

mailto:[email protected]

https://fundrecs.com/depositary.html

Date post:	22-Nov-2014
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AIFMD Depositary - Developing an Operating Model

Economy & Finance