Global custodians fear they would be liable for clients' assets under the draft European directive for alternative investment fund managers (AIFMs) -- and that could have a radical impact on costs.

Some are also concerned about proposed changes to AIFM regulations, which now apply to about €2 trillion of investments, but could be extended to Ucits funds and then further worldwide.

"We are monitoring the legal framework, because it really underpins everything we do, and how these regulations develop in Europe might reshape fund regulation globally," says Tony Lewis, Hong Kong-based head of global custody for HSBC Securities Services.

The wording as it stands in its broadest interpretation would mean it is the depositary's responsibility to account to the fund for financial instruments lost while in its safekeeping, he says.

Lewis is referring to the European directive on AIFM, which could be approved by the European parliament as early as July. In Article 17, the directive looks at the definition of a "depositary", a term which also refers to custodians.

It accentuates custodians' obligations and might ultimately mean that depositaries would have to move those assets onto their own balance sheet, says Lewis.

This will radically change a depositary's way of doing business, he says. "For all of us, that completely changes the landscape because, if the risks and costs of business increase significantly due to substantially increased liability, then we have to re-work our pricing," says Lewis.

In addition, EU regulators are considering whether they should apply the provisions to Ucits funds, which account for about $7 trillion in assets, he adds. HSBC, like many institutions, has given feedback on the draft directive.

Some are hopeful that the current proposals will be watered down.

David Aldrich, London-based managing director at BNY Mellon Global Client Management, says the discussion -- between the European Council, European Commission and the European Parliament -- appears to be moving towards a more sensible position.

Bearing in mind that the current draft of the legislation has 1,699 amendments, it is very difficult to predict the final outcome with any degree of confidence, he says. "It is still a work in progress, but we are getting to a better place," Aldrich says.

He is monitoring drafts of Article 17 and also Article 35 closely. On Article 35, which concerns protectionism, the new directive must enable European investors to access hedge funds from all over the world and not create a "fortress Europe", says Aldrich.

But others feel hopes that the draft will be diluted could be wishful thinking. There is very strong political backing for the directive, says Tony Freeman, executive director at trade processing solutions provider Omgeo in London.

"Some people are mixing up what they would like to see happen and what is happening," he says. "Theoretically there are only minor amendments to be made. I feel it is less likely than more likely, at this point in time, that [the directive] will change substantially. So [for custodians] this could be a radical change that will impact on the cost structure."

The explanatory memorandum accompanying the draft directive states that the financial crisis has exposed a series of vulnerabilities in the global financial system. The funds in question are defined as all funds that are not regulated under the Ucits directive. The sector includes hedge funds and private equity, as well as real estate, commodity and other types of institutional funds.

Meanwhile, as the AIFM directive saga continues in Europe, AsianInvestor revealed recently that Singapore is also considering tightening hedge-fund regulations.