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Burden of proof may weigh down emerging markets

Chris Salih says a European directive on depository liability poses a threat to investment funds

There may be trouble ahead for emerging markets funds if new rules on depositories are passed by the European Union.

Trade bodies and industry experts say the alternative investment funds management directive will tighten liability for depositories if assets become unaccounted for.

The proposal in its current state would only affect non-Ucits funds but EU Commissioner Charlie McCreevy wants protection levels extended to cover Ucits funds. A Ucits depository consultation paper was launched in July, which included views on doing just that.

Emerging market funds are likely to be the hardest hit due to using sub-custodians outside the EU. For example, some non- EU countries such as Russia require securities issued in their own country to be held by a local depository. The fund firm’s main global depository would still be responsible for any losses.

Citibank head of UK fiduciary services David Morrison says: “The AIFM rules mean depositories are now guilty until proven innocent as an inversion of the burden of proof.

“There are bound to be closures if these rules stay as depositories will raise charges or just simply say no to the extra liability. There are custody, investment, market and geographical risks to consider. These are likely to go back to the client in some way.”

The EC has postponed any decisions on the directive depository rules until the completion of the current Ucits review.

The Association of Investment Companies has already responded to the consultation on the Ucits depository function. In its response, the AIC says the directives should recognise the diversity of providers which can perform the function.

The response also states there is no reason why the receipt of payments, safe-keeping of assets and verification of ownership should be performed by a single entity, as there are benefits to spreading activities to specialist services, such as narrowing counterparty risk.

It says: “If obligations are introduced which are too stringent and restrict commercial flexibility, compliance costs (which reduce investment returns to consumers) are likely to outweigh the benefits of the incremental increase in protection for investors that the requirements are purported to deliver.”

AIC public affairs director Guy Rainbird says: “As a credit institution can only delegate to another in the EU, it means you cannot go into places like China and Japan and if you could, the liabilities are likely to be heavy. The universe of those wanting to take on the risks will get smaller.”

Investment Management Association director for international relations Jarkko Syyrila says: “This could be the end of the story for a number of emerging market funds, whether they are Ucits or not. If the legislation goes through as it is, I think there would be massive concerns for all fund groups and I would expect a number of funds to close as a number of depositories will not take on those risks or will only do so for a significantly higher price.”

HSBC global head of product development Adam Fairhead says the big difference is the Ucits directive currently states that depositories are liable for losses that result from the unjustifiable failure to perform their obligations or improper performance of them.

He says: “However, the AIFM says depositories shall be liable to the AIFM and the investors of the AIF for any losses suffered by them as a result of its failure to perform its obligations pursuant to this directive.”

Fairhead says the new wording which sees the removal of the word “unjustifiable” could present a much bigger risk to depositories.
He says “That is a big difference and a big added risk. I expect a middle ground will be found to tackle the problem as it is likely that extra costs will be incurred all the way back to the investor if the proposals went through as they stood.”

Martin Currie head of product development Toby Hogbin says: “All Ucits fund have a depository and the new rules will mean that they are liable for any losses. The problem is that, in some areas, local rules may preclude depositories so they, in turn, will appoint an agent and should anything happen with that agent like fraud or any criminal activity, they will be punished.”

Hargreaves Lansdown investment manager Ben Yearsley says: “If it improves protection, then an additional fee of around 0.5 per cent is probably fair, given the amount of outperformance you would get from emerging markets in the long term. If the fees get significantly higher, there will be a problem. I think a middle ground will be found as is often the case with issues like these in the industry.”

Schroders managing director of UK intermediary business Robin Stoakley says: “Essentially, it is still a proposal. We feel the current Ucits proposals fit the bill perfectly and we feel that if the AIFM directive calls were transferred to Ucits, it would increase or restrict investment or possibly both.

“The big issue would not be a rise of five, 10 or 15 basis points in the total expense ratio, although no one exactly wants to see that, the problem would be the number of custodians dropping out of the market due to the extra responsibilities they would have to take on.”


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