Iain Morse finds that custodians will face greater levels of liability for the assets they safeguard for clients under AIFMD rules.

It's custody banking Jim, but not as we know it. The Alternative Investment Fund Management Directive (AIFMD) is due to take force by the end of 2013. Its overall shape is known; detail on implementation will be announced this summer. Amid a tsunami of banking regulation meant to reduce what regulators like to term ‘systemic risk', the AIFMD has received only fitful attention outside of the hedge and private equity communities. "This is a mistake. The directive may have the effect on banks of turning assets into liabilities," warns Bill Scrimgeour, global head of regulatory and industry affairs at HSBC Securities.

How could this transmutation occur? "I am referencing a comment made 20 years ago about how the branch structure of clearing banks turned from assets to liabilities, and many of those branches have since closed," adds Scrimgeour. By analogy, the custodian banks and depositaries, small and large, local and global, may face similar redundancies among some of their core business lines. In the current environment, sympathy for custodians is short, although they have not failed their clients during even the most acute periods of the credit crunch.

Notwithstanding this unblemished record, article 21 of the AIFMD threatens to treat financial instruments held by a depositary/custodian on behalf of a client as potential liabilities, effectively placing them on the custodian balance sheets. If loss of instruments takes place, the depositary may be held liable to replace them like for like. In pursuit of a level regulatory playing field, the EU is almost certain to extend this principle from alternatives to mainstream by amending the proposed UCITS V Directive to the same effect. The regulator's message is simple; there will be no escape.

Central to the regulatory intent of the AIFMD is a requirement that alternative funds marketed in the EU must use a depositary. Primarily intended to capture and regulate hedge funds and private equity funds that do not at present have to appoint a depositary, the Directive will also capture any fund not regulated as a UCITS fund. There will be exemptions based on funds with small assets under management and small numbers of investors, but the qualifying threshold is expected to be set low. Depositaries will be required to accept hugely elevated levels of liability in relation to the assets they safeguard for clients.

Traditionally, depositary liability has been based on negligence - loss of records, acceptance of a forgery, failure to act, or acting without instruction and so on. In the wake of the credit crunch, regulators decided to radically alter the definition of depositary liability. This became evident in the earliest, 2009 draft of the AIFMD which extended the definition to include loss of investment value. There was a tactical retreat from this extended definition due to strong resistance from industry lobbyists, but this might be reversed after the outcome of consultation on ‘level 2' implementation measures. As matters stand, the AIFMD looks to be a curate's egg, good and bad in places. Some of it is a codification of current best practice for depositaries.

These include a duty to safe-keep financial instruments held under custody and negligence or failure to perform regulatory duty another.

Also, the use of delegation of powers to a subcustodian, where financial instruments held by the sub-custodian must be held separately and so on.

But the Directive takes another turn when it introduces new and far more rigorous standards in relation to cash management and monitoring.

Next, it proposes strict liability to return lost financial instruments held in custody by the depositary or its appointed sub-custodians. Direct legal liability is not imposed on sub-custodians; these may not be EU-regulated entities. However, there is an allowance for liability transfer, depending on a contract formed directly between the beneficial owner of the relevant instruments and a regulated sub-custodian or other third party service provider. This, of course, is a departure from current practice where separate contracts run from owner to custodian and then from custodian to sub-custodians.

There are grounds on which the custodian can escape liability for loss. These depend on a custodian being able to prove that the relevant losses were caused by events ‘the consequences of which would have been unavoidable despite all reasonable efforts to the contrary'. Even so, the custodian is exposed to a whole new range of event risk as a result of which it might face a legal claim of liability from a client.

At one end there are settlement failures in non-delivery-versus-payment (DvP) markets, non-exclusive control of accounts under clienthypothecated account structures and any transaction reversals or other unilateral actions taken by central securities depositories (CSDs). Then there are deficiencies in market infrastructure such as systemic market failures, sub-standard market infrastructure, and fraud by a sub-custodian or other agent outwith the custodians standard duty of supervision.

More controversially, local market conditions such as extreme volatility, abnormal levels of default, not to mention sudden market closures and abnormal currency devaluation could all serve as grounds for litigation. Presumably, the regulators were thinking about the example of Iceland when framing this part of the Directive.

Then there is counterparty failure in repo and lending, derivative transactions and prime brokerage, not least where re-hypothecation is involved.

Sooner or later, custodians will stress test their financial capacity to meet these liabilities out of un-hypothecated, ‘free' capital reserves, or perhaps using some form of insurance against each type of risk. Stress testing will have to include scenarios all too familiar by now. These might include sovereign default by a euro country or, perhaps, debt ‘re-scheduling' with a 50-70% haircut for investors. Then there is war, or the consequences of systemic political failure.

The possibilities are endless. A relatively minor asset ‘loss' under the AIFMD might, set against a context of broad economic distress, suddenly become much more serious.

This systemic risk might start with a reduction of liquidity between banks. In these conditions, replacement of loss could become very expensive or even, for a period, impossible. If custodians were to be caught up in a new credit crisis, beyond any control, effectively depleting their free capital ratios, some might be forced to withdraw from business lines which served to increase their overall balance sheet risk. Some markets, particularly those in developing economies where infrastructure is poor and market regulations not always observed, will become too risky for custodians to enter even via a sub-custodian. It is easy to see how this could happen. Withdrawal by one custodian could trigger withdrawals by others. Think Iceland, think Hungary.

One obvious response to this brave new world of regulation is simple; close down the business lines capable of generating these new, unquantifiable risks. The far stricter liability standards set to be introduced under the AIFMD and UCITS V will significantly re-adjust the economic risk rating given to depositary and custody functions. It seems certain that many participants will leave the market entirely or curtail their business activities to reduce risk.

Consider the position of local ‘depo-banks', a financial cottage industry scattered throughout the EU. The depos typically service ‘captive', inhouse assets, or have their services sold as part of a wider package to local asset managers and insurance companies. Sooner or later, the possible consequences of AIFMD and UCITS V will oblige review of whether a depo function is still a main activity.

The other response is to seek compensation for these new, regulatory risks. "We think there will have to be a step-rise in fees," warns Stuart Catt, senor consultant at Mercer's Sentinel Group. The new regulatory environment means that the fixed fees and activity based fees levied by depositaries and custodians must rise. Inevitably there will be a new search for cost-cutting measures and, on the supply side, for new economies of scale that will only become evident as the overall strength of custodian balance sheets are re-assessed.

Pension funds, and all other users, will review their depositary and custody arrangements.

Aside from mere cost, trustees and pension boards will need to be certain that a depositary can meet the cost of any loss of assets. If a depositary failed to make restitution due to capital inadequacy, the trustees might be held liable for employing them. Some might pay a premium to eliminate this possible risk. Finally, there is no obligation for any bank to offer depositary or custody services. In a market where capacity willbe compressed relative to demand, custodiansmay not want some clients at any price.