EU watchdog unveils rules to protect customer assets

Date: Thursday, November 17, 2011
Author: Huw Jones

European Union regulators has unveiled rules to better protect customers' assets from 2013, sparking a funds industry warning that typically low custodian fees would have to rise.

The European Securities and Markets Authority (ESMA) published a 500-page set of rules on Wednesday to flesh out the EU's new law regulating alternative investment fund managers (AIFMD).

A core element is to make depositaries, which hold customers' assets for safekeeping, more liable for those funds. The EU watchdog said if one of three criteria -- focused on ownership rights -- were met to determine that an asset was lost, then liability would be triggered.

"This assessment is crucial in determining whether a depositary must subsequently return an asset," ESMA said in a statement.

The aim is to apply a key lesson from the financial crisis and the recent bankruptcy of futures broker MF Global, where $600 million in customer funds have gone missing.

The industry had hoped the ESMA would take a softer line on liability, though it had to act within the framework law.

"We welcome the open and transparent process ESMA has run. However, we remain extremely worried about the liability standard imposed on depositaries," said Jiri Krol, director of government and regulatory affairs at AIMA, the hedge fund industry group.

"If a depositary is held liable for the loss of financial instruments which are kept by custodians over whom the depositary has no control, significant costs will be created," Krol said.

AIMA, whose members use depositaries to hold customer assets, has estimated that increased liability would cost $6 billion, and investors would end up footing the bill.

Jonathan Herbst, a financial services partner at Norton Rose, said the liability rules were probably the best the industry could hope for, given events during the financial crisis and pressure to protect customer assets better.

"MF Global has brought all this into focus. It's going to increase custodian liability, as today they have negotiated themselves out of a lot of these liabilities," Herbst said.

The rules will make the custody market warier and more expensive, with the ESMA loss criteria "tested in the line of fire", meaning the courts.

"These are not well-trodden legal grounds, and these concepts don't exist in law, and you also have member-state law underneath all of this," Herbst said.

The rules also set out duties on depositaries to monitor the cash flows of the alternative investment fund and the consequences when an asset held in custody is lost.

Karsten Langer, chairman of European private equity industry body EVCA, said he was concerned about the role of depositaries "whose interference in the investment decision would be of concern to fund managers and investors alike, by upsetting the tight alignment of interests which already exists in our industry".

The ESMA rules are in the form of advice to the EU's executive European Commission, which is expected to approve them, though it does have powers to request some changes.