Proposed reforms under the Alternative Investment Funds Management Directive that would see custodians held liable for asset losses could drive a wave of consolidation and alter the way the industry operates forever.

Under AIFMD, which governs all non-Ucits funds and must be implemented across EU states by July 2013, alternative investment managers must appoint a depository for each fund they manage.

But clearly the repercussions of imposing liability on custodians for loss of assets would extend well beyond the EU into Asia.

Under the proposal, the burden of proof would be shifted onto custodians to show that any loss of a fund’s assets had arisen beyond its “reasonable control”. This has also been included in the EU’s consultation on Ucits V.

Speaking at the International Transfer Agency Summit Asia 2012 in Hong Kong, heads of legal compliance and offshore fund servicing suggested that this proposal risked triggering a wave of industry consolidation.

Damien Barry, vice-president of offshore fund services for Asia at State Street Bank and Trust, said it appeared custodians would even be held liable for losses incurred by fraud related with prime brokers appointed by the hedge fund managers.

“The selection of prime broker is really an investment decision, rather than a safety decision,” says Barry. “Our ability to safe-keep assets that are not in our control, but rather in the control of the prime broker, is going to be challenging.”

If the reform proposals are implemented in present form, costs would rise significantly for the alternative funds industry as custodians would need to price in that risk of potential liability for different assets in various markets.

“Providers who are able to price that risk would be successful, but a lot of them might struggle to do that,” says Barry, indicating that it would drive industry consolidation.

A study conducted by Ernst & Young this March estimates that if a custodian is made liable for asset losses for the entire sub-custody chain, including unaffiliated agents such as prime brokers, the total cost of the reform to the European alternatives industry could exceed $6 billion.

Panel members agreed that AIFMD would change the way alternative investment funds operate, since this potential liability would alter the way a custodian works with a fund’s prime brokers.

But Mark Shipman, a partner at Clifford Chance who specialises in China-related product development and RMB investment funds and provides regulatory advice to fund managers and asset houses, suggests an industry push-back against such a liability on custodians is possible.

He notes a similar liability on asset losses was proposed on custodians in Hong Kong about a decade ago, when the government implemented its private-managed pension scheme, the Mandatory Provident Fund (MPF).

In the end the industry succeeded in persuading the Hong Kong government not to impose such standards on custodians supporting the MPF.