Custodians close ranks over AIFM proposals

Are custodians facing unfair punishment because a criminal like Bernie Madoff went undetected?

Global custodians have gone to ground over the looming European legislation on alternative investment fund managers (AIFM) which could be passed as early as July.

No one is commenting publicly as crunch time approaches, but they are all working on this behind the scenes - understanding the proposals and lobbying the regulators.

Off the record, custody executives say it is a headache, and hope the new laws will not be an overreaction to the role of hedge fund managers in the financial crisis of 2008.

The water around the draft laws is murky. What is clear, however, is that all custodians AsianInvestor spoke to over the past two months are wary about Article 17 of the draft of the EU directive on AIFM.

It refers to custodians as repositories and could change how a custodian is defined. If so it may extend balance sheet responsibilities which could hike up business costs.

In a comment representative of many execs' views, one custodian chief says: "I think the European regulators don't necessarily always appreciate the subtleties of all the regulation and all the practicalities of what they are doing."

Some are cross they are all unfairly tainted with the same Madoff brush. Bernie Madoff was a criminal who did not abide by any laws, and there is anger that all financial participants are being assumed to also have a cavalier attitude towards the law.

Laws of any kind do not necessarily stop criminal activity. But if these European laws are passed in the draft form, it will certainly change the business model of financial institutions.

Some argue that extending legal obligations is going down the wrong path. No amount of legislation, if not enforced by the authorities, may have stopped Madoff, argue custodian bankers.

But there are two big 'ifs' everyone is watching - if the AIFM gets passed in the current form and if the spirit of the proposed legislation is extended to the Ucit framework for mutual funds.

Ucits, as a brand, have gained credibility in recent years with Asian investors and this is another worry. If laws governing European custodians, who are the custodians of Ucits, are going to change radically then that will impact on fees, argue custodians.

Last month, Tony Lewis, head of global custody for HSBC Securities Services worldwide, told AsianInvestor that custodians and banks could be in for a radical change in the way they do business.

Current laws require a custodian to exercise appropriate due diligence and to make sure assets are safe and held in an appropriate manner with an appropriate fee charged.

"That really has nothing to do with Madoff because that was a complete fraud," says the custodian, quoted earlier, off the record.

"But the way the regulations are being drafted, you could almost interpret them to read that the custodian would have an obligation to return assets even if assets become worthless in the course of business activity between other parties."

For example, if a hedge fund manager was trading derivatives, those assets would not necessarily sit in a vault; instead they would be traded on an exchange and there would be a contract between two or more parties. Then, if one of those parties goes bust, whose responsibility is that, the custodian or the institutions that entered into the contracts?

Obviously, custodians have no desire to assume such a responsibility. In addition, if you have short positions, those securities could be borrowed from a third party and then lent. Typically, the prime broker is lending or borrowing securities from a custodian. Collateral is given in exchange for that, at which point it becomes part of the balance sheet. Again, the custodians ask, should they be entirely responsible for contractual obligations?

In the explanatory memorandum, the context for the draft is outlined. It states that while AIFMs were not the cause of the crisis, recent events have placed severe stress on the sector.

"Funds of hedge funds have faced serious liquidity problems; they could not liquidate assets quickly enough to meet investor demands to withdraw cash, leading some of the hedge funds to suspend or otherwise limit redemptions," the memorandum says.

At the time of going to press, AsianInvestor did not receive a comment from a representative of the EU Parliament.

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