looking set to continue, Malta’s investment
fund industry could be severely impacted if the
jurisdictional anchor for depositaries is not
removed.2
The Case for A European Depositary
Passport
Introductory Remarks
This paper is structured as follows. Part I will
examine the revised rules applicable to
depositaries in the post AIFMD/UCITS V
landscape. Part II is divided into four parts. Part
IIA will argue that the restriction on
depositaries to provide their services across
borders represents a breach of the freedom of
movement of services enshrined in article 56 of
the Treaty on the Functioning of the European
Union (the “TFEU”). Part IIB will then illustrate
that the prohibition on depositaries to passport
their services across the EU is likely to increase
systemic risk. Part IIC will show that the
absence of a depositary passport is untenable
in light of the current position under the
Alternative Investment Fund Manager’s
Directive (the “AIFMD”)3 (which effectively
allows a depositary passport for AIFMs
managing third country AIFs). Part IID will
analyse the implications arising from the failure
to introduce a depositary passport for Malta.
The absence of a depositary passport is one of
the last remaining barriers to the unhindered
cross-border activity of UCITS and Alternative
Investment Funds (“AIFs”). It haemorrhages the
concept of a single market and impedes market
players from reaping the full benefits thereof.
Hitherto, one of the main arguments posed
against the introduction of a European
depositary passport has been rooted in the
premise that passporting rights for depositaries
should not be introduced before the role and
responsibilities of depositaries have been
harmonised across Member States.1
Whilst there remained divergences in national
laws regarding the regulation of depositaries,
this restriction on the freedom to provide
depositary services on a cross border basis
could have been justified. However, in the postAIFMD/UCITS V era and in light of the high
standards to which depositaries are now
regulated, this argument no longer holds water.
Part III will argue that, in order to enhance
investor protection, the implementation of a
depositary passport must be buttressed by
other legislative initiatives, namely: (i) more
robust rules governing asset segregation; (ii)
limits on reuse of AIF assets.
The central thesis of this paper is that the
introduction of passporting rights for European
depositaries is a necessary development in the
evolution of the European Investment fund
industry. Without it, there is a risk of a lack of
competition in the depositary space and
increased systemic risk. This argument bears
particular resonance within the local
dimension. Indeed, with the clock ticking down
on 2017, and the dearth of onshore custodians
Although the introduction of a depositary
passport has (thus far) only been contemplated
within the context of the UCITS framework,4
2
See Christopher Buttigieg, ‘Regulation of Funds in
Malta: The Challenges Ahead’ JFRC 21(2), 121, 132.
3
Directive 2011/61/EU on Alternative Investment Fund
Managers [2011] OJ L 174/1.
4
See ‘UCITS Consultation on Product Rules, Liquidity
Management, Depositary, Money Market Funds, Longterm
Investments’
(2012)
<http://ec.europa.eu/internal_market/consultations/doc
1
See Responses to Consultation on ‘Product Rules,
Liquidity Management, Depositary, Money Market
Funds,
Long-term
Investment’
(2012)
<
http://ec.europa.eu/internal_market/consultations/2012
/ucits/registered-organisations/state-streetcorporation_en.pdf> accessed 21 February 2015.
1
this paper will argue in favour of the
introduction of a depositary passport for both
UCITS and AIFs.
(falling outside the remit of the UCITS Directive)
to appoint a depositary. Indeed, Member States
enjoyed significant discretion as to: (i) whether
the appointment of a depositary was required
for AIFs domiciled in their jurisdiction; (ii) which
entities were allowed to act as a depositary;
and (iii) what obligations where incumbent on
depositaries holding AIF assets.8 This led to
differing levels of investor protection across the
EEA and provoked legal uncertainty.
Part I - The Revised Regulatory Architecture
Opening Commentary
Depositaries are crucial nodes in the overall
investment fund architecture – legal certainty
in this field is paramount. Cognizant of this, the
European Commission developed a strong
desire to clarify, homogenise and strengthen
depositary functions.5 This desire manifested
itself in the revised rules governing depositaries
in the Alternative Investment Fund Manager’s
Directive (the “AIFMD”), which were
subsequently reflected in UCITS V6 (which must
be transposed into national law by Member
States by 18 March 2016).7
This position has been rectified by the AIFMD.
In terms thereof, each AIFM is required to
appoint a single independent custodian for
each AIF under management. Such entity must
be (i) a credit institution; (ii) an investment
firm; (iii) an eligible entity under UCITS; or (iv)
an equivalent non-EEA entity (in the case of
non-EU AIFs).9 In the case of EU AIFs (save for
an intermittent period expiring in 2017) the
custodian must be established in the home EU
Member State of the AIF.10
Both heads of legislation have harmonised the
core safe-keeping and oversight functions of
depositaries. They affirm the principle of a
single depositary function and also contain
rules on the delegation and liability of
depositaries, imposing high standards for the
selection and on-going monitoring of subcustodians, whilst also imposing strict liability
for loss.
The AIFMD imposes extensive duties on the
custodian including sake-keeping,11 custody and
oversight of AIF assets (i.e. all financial
instruments), as well as the effective and
proper monitoring of the AIF’s cash flows.12
Depositaries also have a duty to segregate
assets
(including
conducting
regular
13
reconciliations); a duty to exercise all due skill,
care and diligence when delegating authorised
functions;14 and are liable to the AIF (or its
investors) for all losses of financial instruments
held in custody.15
The AIFMD in Focus
Prior to the introduction of the AIFMD there
was no requirement for investment funds
s/2012/ucits/ucits_consultation_en.pdf> accessed 23
February 2015.
5
See Dirk Zetzche, The Alternative Investment Fund
Managers Directive: European Regulation of Alternative
Investment Funds (Kluwer 2012) 410.
6
Directive 2014/91/EU (amending Directive 2009/65/EC)
on the coordination of laws, regulations and
administrative provisions relating to undertakings for
collective investment in transferable securities (UCITS)as
regards depositary functions, remuneration policies and
sanctions [2014] OJ L257/186.
7
Ibid article 99 (1).
8
See Zetzche (n 5) 412.
See AIFMD (n 3) article 21(3).
10
Ibid article 21(5).
11
Ibid article 21(8).
12
Ibid article 21(7).
13
Ibid article 21(8)(b)(ii).
14
Ibid article 21(11)(c).
15
Ibid article 11(12).
9
2
Furthermore, there must be a written contract
in place between AIFMs (or AIFs, where they
are self-managed) and depositaries which must
contain a very broad range of contractual
particulars, inter alia covering the depositary’s
services and liability, confidentiality obligations
the re-use of assets and the exchange of all
necessary information.16
UCITS V also contains strict rules on the
delegation and liability of depositaries. One key
point of difference is that depositaries of AIFs
can contractually limit their liability for loss of
assets in custody (provided that such discharge
is objectively justified). It is not possible for a
UCITS depositary to exclude or limit its liability
under contract. This difference seemingly
reflects the view that retail investors in UCITS
require a higher degree of protection than
professional investors who invest in AIFs.21
UCITS V in Focus
There is an unwritten rule that UCITS funds
(which are aimed at retail investors) have to be
regulated to the same standard or higher than
funds which fall under the umbrella of the
AIFMD (which are aimed at professional
investors). Indeed, UCITS V embodies a clear
attempt to align the AIFMD rules governing
depositaries with those of UCITS funds.
Part II
Part IIA – Freedom of Establishment
The introduction of a depositary passport is a
sensitive issue which posits itself at the
intersection of two important objectives: (a)
unrestricted mobility of entities within the
EU/EEA; and (b) the need to safeguard the
interests of investors. In this author’s view the
introduction of a depositary passport will fulfil
both of these objectives.
In terms of UCITS V (similar to the AIFMD) the
fund must appoint a single depositary. The
depositary can be an EU credit institution, a
national central bank or another entity
authorised by an EU member state to act as a
UCITS depositary.17 Further, in a parallel vein to
the AIFMD, the appointment of the depositary
must be evidenced by means of a written
contract.18
The freedom to provide services across borders
is a central tenet underpinning the effective
functioning of the Internal Market (and is
protected under article 56 of the TFEU). On the
basis thereof, if custodians consider that there
exist business and organisational advantages in
providing their services across borders, this
right should be protected by the said article 56.
In an analogous manner to the AIFMD, cash
monitoring obligations have been imposed
upon depositaries.19 This will enhance the
ability of depositaries to act as the “eyes of the
investor”, as depositaries will need to have a
granular knowledge of UCITS' cash balances and
transfers into and out of cash accounts.20
If custodians are allowed to provide their
services across borders the internal market will
be strengthened and investor protection will be
enhanced as a result of increased competition.
16
See Commission Delegated Regulation (EU) No
231/2013 article 83.
17
See UCITS V (n 6) article 23.
18
Ibid article 22.
19
Ibid see point (16) of the preamble.
20
Trevor Dolan ‘UCITS Brings Convergence of Depositary
Role with AIFMD’ (2015) JIBFL 64B.
21
This feature of UCITS V seems unduly restrictive. From
a practical perspective it threatens to dry up the market
for depositaries, which could in turn have the effect of
concentrating risk in a few large market players, bullish
enough to take on the risk.
3
Indeed, the introduction of a passport will
enable depositaries to offer their services on a
European level and challenge national market
leaders. This will have a disciplining effect on all
custodians, who, fearful of losing out on ‘local’
business will be forced to move towards more
productive patterns and perhaps even revise
fee structures to remain competitive.
refuse to provide services to small funds,
where, on balance, such depositaries consider
that the income derived from servicing such
funds is outweighed by the potential liability to
which they will be exposed.
In such a situation, the fund will not be able to
continue to operate under the AIFMD or UCITS
regime (as applicable) as it will be required to
appoint a depositary located in its jurisdiction.
If no custodian in its jurisdiction is willing to
provide depositary services to the fund, the
fund will be forced to close down its operations
(as it will not have the option to search for
depositaries in other EU Member State who
may be willing to provide depositary services
thereto).
It will also offer funds a bigger choice of
depositaries to choose from, all of which are
required to conform to high standards in terms
of the AIFMD and UCITS V. This should allow
funds to seek out services of the best quality at
the cheapest price.
Furthermore, in addition to the above, a
depositary passport would also enable
managers to use the same depositary for all
funds domiciled in different EU jurisdictions,
and may enable them to negotiate favourable
terms for investors based on economies of
scale.22
This could trigger investors to pour their excess
cash into larger UCITS or AIFs which
depositaries are willing to service. Investors
may also choose to place their money in bank
deposits. Indeed, this is not an unlikely
possibility for investors in UCITS funds, many of
whom are after the protection of principal.
Part IIB - Increase in Systemic Risk
The implications inhering from the failure to
introduce a depositary passport should not be
considered in a vacuum. As elucidated above,
UCITS V and the AIFMD have resulted in the
imposition of strict liability on depositaries. This
has made depositaries ‘de facto’ insurers for
fund assets.
Investor cash, formerly spread across a broad
range of UCITS/AIFs will be concentrated in a
contracted universe of funds and bank deposits.
This will increase the systemic importance of
such funds/banks as the failure thereof would
cause losses to a broader spectrum of
investors.
From a practical vantage point, this has led to
an increase in depositary fees and has also
induced certain banks to hive off depositary
services from existing business models. A
further corollary arising from the imposition of
strict liability is the following: due to the
increased risk inherent in providing depositary
services to funds, certain depositaries may also
Furthermore, AIF investors, who have a greater
appetite for risk, may invest directly in the
underlying financial products (if the fund in
which it is investing is forced to close down its
operations due to the absence of a local
custodian to provide services thereto). In a
financial ecosystem with investment funds as
risk buffer, the risk of loss would be
exacerbated. Indeed, AIFs are managed by
qualified investment managers which possess
22
This argument was inspired by the response of AXA
Investment Managers to the UCITS VI Consultation (n 4)
8.
4
better investment and analytical skills than
investors acting individually.
The AIFMD therefore allows a depositary
passport through the backdoor for AIFMs
managing non EU-AIFs.24 On the basis of the
aforesaid, the reason as to why the AIFMD
would negate the right for European
depositaries (most of which are investment
firms and credit institutions regulated to the
highest of standards under under MiFID and the
CRD) is puzzling and indefensible.
It is also not unlikely that cash formerly
invested by investors in AIFs/UCITS will be
shifted to unregulated investment vehicles
which enter into vogue in order to meet
investor demand. Such vehicles may manifest
themselves in a multiplicity of different guises,
including offshore funds.
Part IID - The Implications for Malta
Paradoxically, therefore, the imposition of strict
liability on depositaries may detract from the
level of protection afforded to investors.
The ramifications resulting from the failure to
introduce a depositary passport will be
particularly grave for Malta. There are currently
only eight depositaries located in Malta.
A depositary passport, it is submitted, would
suppress these negative externalities by
allowing small-scale funds to look overseas to
the appointment of a foreign depositary where
none are available onshore to provide services
thereto. This will allow them to remain in
operation (instead of closing down their
operations) and this will retain investor monies
scattered across a broad universe of investment
vehicles.
Should a depositary passport not be
introduced, it is questionable whether such
depositaries have the capacity to service all AIFs
domiciled in Malta post-2017.25 It will also
severely hamstring Malta’s possibility to attract
further AIF business in the future.
Furthermore, in this author’s view, the failure
to introduce a depositary passport could also
negatively impact the local PIF industry. Indeed,
de minimis managers might be less likely to set
up PIFs in Malta if they are contemplating
conversion to AIF status in the future. This
could, for instance, be the case if the de
minimis manager is looking to set up a PIF in
Malta in order to establish a healthy track
record and gauge interest from investors
(following which the manager might intend to
convert its PIF/s into AIF/s). If there are no
depositaries to service such AIFs, the de
minimis fund manager might look to competing
jurisdictions which offer alternative fund
structures for de minimis managers.
Part IIC- The Anomalous Situation
In veering from the above, the requirement to
have depositaries situated within the same
Member State as the funds whose assets they
have custody over is no longer tenable in light
of the current position under the AIFMD.
In terms of the AIFMD, each AIFM is required to
appoint a single independent custodian for
each AIF under management. However, in the
case of AIFM managing third country AIF, AIFMs
may appoint a depositary in: (a) the third
country where the AIF is established; or (b) the
home Member State of the AIFM managing the
AIF; or (c) the Member State of reference of the
AIFM managing the AIF.23
24
23
This argument was inspired by See Zetzche (n 8) page
415.
25
See Buttigieg (n 5) 132.
See AIFMD (n 3) article 21(5)(b).
5
Part III – Asset Segregation and Limits on
Reuse of Assets
In practice, two models have emerged for
holding AIF assets under the AIFMD:29
Opening Commentary
Model 1: sub-custodians are holding assets for
multiple depositary clients in omnibus accounts
established in the name of all delegating
depositaries; and
Although the arguments in favour of the
introduction of passporting rights are strong,
the existing legal framework is not a panacea.
In order to ensure utmost protection to
investors, the introduction of a depositary
passport must be buttressed by other
initiatives: (i) more robust rules governing asset
segregation; (ii) limits on re-hypothecation of
AIF assets.
Model 2: sub-custodians are holding third party
assets from various depositaries in different
accounts for different delegating depositaries.
Therefore, each account contains assets of AIFs
of the same delegating depositary, with assets
of AIFs of other depositaries being kept in
separate accounts.
Asset Segregation
On 1st December 2014, ESMA launched a
consultation requesting industry feedback on
the above-mentioned holding models.30
Regrettably, ESMA did not recommend a subcustody model providing for segregation on an
AIF by AIF basis (irrespective of which custodian
was the underlying delegator).
Asset segregation at both custodian and subcustodian level is fundamental in order to
improve investor protection. In terms of the
AIFMD and UCITS V, the notion of segregation
becomes thorny in the event of sub-delegation
of custody functions.
Indeed, from a reading of article 99(1)(a) of the
Level 2 Regulation, it is manifest that the third
parties to whom custody functions are
delegated have to distinguish assets of AIF
clients from: (1) their own assets; (2) assets of
any other client of that third party; (3) the
assets belonging to the depositary itself; as well
as (4) the assets belonging to clients of the
depositary which are not AIFs.26
The word ‘regrettably’ is used above as, in this
author’s view, neither of the above two options
ensure sufficient investor protection. The
pooling of AIF assets in omnibus accounts,
could lead to difficulties in tracing investor
assets in the event of insolvency of the subcustodian in question. The cleanest option, it is
submitted, would be to have segregated
accounts for each AIF. In the event of
insolvency it would then be possible to identify
which assets belong to which AIF. This would
enhance investor protection.
Effectively, this means that at sub-custodian
level, AIF assets may be kept together with
assets of other AIFs. This is confirmed by Recital
40 of the AIFMD which allows sub-custodians to
maintain omnibus accounts for multiple AIFs.27
The position adopted under UCITS V is similar
(as sub-custodians may maintain omnibus
accounts for multiple UCITS).28
Taking the scenario illustrated hereunder as an
exemplar, this author will illustrate this thesis:
29
See ‘Consultation Paper: Guidelines on Asset
Segregation
under
the
AIFMD’
(2014)
<
http://www.esma.europa.eu/system/files/20141326_cp_-_guidelines_on_aifmd_asset_segregation.pdf>
accessed 26 February 2015.
30
Ibid
26
See Delegated Regulation (n 16) article 99(1)(a).
See AIFMD (n 3) point (40) of preamble.
28
See UCITS V (n 6) point (22) of preamble.
27
6
securities do not lie idle.34 Such assets are often
re-hypothecated
by
the
custodian’s
counterparty. Indeed, the AIF’s assets could be
‘churned’ several times.
In the situation where assets of a particular AIF
(hereinafter referred to as “AIF 1”) have been
re-hypothecated31 by the sub-custodian and the
assets of such AIF are commingled in a pooled
omnibus account with assets of other AIFs (the
“Other AIFs”) whose assets have not been
rehypothecated, the Other AIFs may be bound
(together with AIF 1) to absorb losses arising
from any shortfall in the event of insolvency of
the sub-custodian. This would be prejudicial to
investors in the Other AIFs, whose assets could
be easily traceable.32
In such a situation, in the event of insolvency of
the custodian’s counterparty (or the
counterparty’s counterparty in the event of
further rehypothecation) the re-hypothecated
assets may be drawn into the insolvency of
such counterparty. In such a situation, the
investors in the AIF would be prejudiced.
In this author’s view, in order to rectify this
problem, the AIFMD should implement similar
provisions to those contained in UCITS V which
inter alia provide that any assets reused by the
depositary must:
Limits on Re-hypothecation
Custodians and sub-custodians often rehypothecate assets which they have custody
over. In terms of the AIFMD there are no such
restrictions on re-use of assets, as long as such
right of re-hypothecation is disclosed to
investors. 33
(a) be covered by high-quality and liquid
collateral received under a title transfer
arrangement;35 and
Indeed custodians often transfer AIF assets as
part of repo and securities lending transactions.
For instance, securities may be lent by a
custodian (or sub-custodian) to third parties in
need of particular securities to meet a short
position. Alternatively, the AIF’s assets may be
transferred by the custodian (or sub-custodian)
as collateral in exchange for obtaining repo
finance.
(b) the reuse of the assets must executed for
the account of the UCITS (implying that the
depositary may not transfer/lend securities for
the purpose of generating profits for itself).36
In a deviation from the UCITS framework,
however, this author is of the view that
minimum haircuts should be applied on the
collateral received by the depositary (10%
above market value of the reused assets for
instance). This will ensure that the investors of
the fund are sufficiently protected in the event
that the re-used assets are never returned.
Notably, pursuant to the securities leg of a repo
or securities lending transaction effected by the
custodian (or sub-custodian), the transferred
Concluding Remarks
31
In order for this to be done the possibility of rehypothecation must be contemplated in the custody and
sub-custody agreements and the possibility of re-use of
AIF assets must have been disclosed to investors.
32
Indeed, investors in the Other AIFs should not be
bound to bear any losses arising from inability of the SubCustodian to trace re-hypothecated assets belonging to
AIF 1 (as investors in AIF 1 would have knowingly
invested in a ‘riskier’ AIF’ - indeed, the possibility of rehypothecation would have been disclosed in the
prospectus of such fund).
33
See Dolan (n 20)
This paper has shown that the introduction of a
depositary passport is necessary in order to
34
Paech Philipp, “Shadow Banking: Legal issues of
collateral assets and insolvency law”, Briefing Note for
the European Parliament ECON Committee, June 2013,
page 24.
35
See UCITS V (n 6) article 22(7)
36
Ibid.
7
‘complete’ the internal market for investment
funds. The failure to introduce passporting
rights for depositaries would increase systemic
risk and is indefensible in light of the quasidepositary passport afforded to AIFM managing
third country AIFs.
In order to ensure that the interests of
investors are safeguarded, the introduction of
passporting rights for depositaries must be
coupled with other initiatives, namely, clearer
rules on asset segregation and limits on the
reuse of AIF assets. Once this is done,
arguments against the introduction of a
depositary passport under the AIFMD and
UCITS VI will be substantially dampened.
8