Should Large Clients of Custodians Seek Extra Protection?

Anyone buying a European mutual fund now receives enhanced protection from custodial risks. Do institutional investors need to ask for equal treatment?

Under Europe’s Alternative Investment Funds Directive (AIFMD), which came into force in 2013, fund depositaries have to indemnify investors in the region’s hedge funds against possible losses caused by fraud or negligence at the level of the custodian or sub-custodian.

Now the principle of depositary liability is being extended to Europe’s retail mutual funds. The incoming, fifth version of Europe’s UCITS rules, which take effect in 2016, align liability rules with those of AIFMD and extend the level of cover to include the central securities depositaries (CSDs) in the markets in which a UCITS invests.

These additional safeguards for fund investors appear to put the large, institutional investor clients of global custodians at a disadvantage—unless they have negotiated equivalent terms in their contracts.

Mutual funds and segregated institutional mandates command a roughly equal share of global assets under management (AUM). According to end-2014 data from the International Monetary Fund and the US Investment Company Institute, mutual funds represent 41% of the US$76 trillion in global AUM, with segregated mandates accounting for 36%.

In Europe, the split between assets in funds and assets in segregated mandates is 48/52, according to the European Fund and Asset Management Association.

Judith Donnelly, a London-based partner at law firm Squire Patton Boggs, told Thomas Murray IDS that the principle of apportioning liability to fund depositaries for safekeeping makes sense.

“There’s an economic rationale for requiring the body that has control of the investments to be liable for any losses,” said Donnelly.

“That incentivises the party to take reasonable care to avoid the losses and it’s why we have the law of negligence in the first place.”

Donnelly advises clients to check the details of custodial contracts when considering a new asset management relationship.

“A fund manager may tell a prospective client: ‘we’ve entered into an agreement with a custodian, who is not liable for anything except gross negligence’, a legal term that means deliberate incompetence by the custodian,” she said.

“The client may then demand that the definition of liability to be tightened up, forcing the fund manager to negotiate with the custodian,” she added.

According to Mark Schoen, head of asset owners solutions at BNP Paribas Securities Services, many pension fund trustees are still grappling with the concept of depositary liability.

“Pension fund trustees may make this request, but are often not that familiar with what an indemnity against loss from the failure of a custodian and sub-custodian means,” said Schoen.

Estimates vary regarding the cost of converting a segregated mandate into a fund with AIFMD-level protection against safekeeping risks.

“AIFMD can be quite expensive,” said Squire Patton Boggs’ Donnelly

“We’ve seen quotes of 25-30 basis points to set up an alternative investment fund for a single European investor. That covers reporting, the risk management and the cost of the depositary, which includes liability.”

BNP Paribas’ Schoen cites a lower figure.

“As a depositary, the costs of servicing funds with AIFMD risk does vary,” said Schoen.

“But it’s modest, compared to the figures of 10 basis points or more being talked about a few years ago. There are operational costs involved, such as greater scrutiny of the fund’s custodians, higher reporting requirements, more intensive oversight of the fund manager and, because of the indemnity we offer to clients regarding the loss of the assets held in safekeeping, greater capital costs under the new Basel III regulations,” he said.

“It was the new capital cost of the indemnity that was the biggest worry for many custodians, but it’s turned out to be more modest than thought,” added Schoen.

“The cost of the indemnity is probably ½ to 5 basis points, depending on the manager and the markets involved.”

Schoen told Thomas Murray IDS that, up to now, BNP has seen relatively few such requests from its institutional investor clients.

“We’ve seen some demand from large clients in the Nordic region and the UK for an indemnity against custodial loss and we will consider such requests, depending on the size of the client and the markets involved,” said Schoen.

According to Stephen Merry, director at Thomas Murray IDS, a convergence in the levels of contractual protection offered by custodians to different categories of client is only a matter of time.

“My view is that we’ll eventually see an alignment here,” said Merry. 

“It is very unlikely that pension funds, insurance companies and sovereign wealth funds will sit back and watch risky alternative investment funds getting enhanced protection while their stable, long-only fund faces worse liability terms. We are telling our larger clients to at least ask the question of their service providers,” he said.

The extension of indemnities to more and more clients of those service providers may also change custodial business models, predicts Merry, with the trend favouring firms with their own networks of sub-custodians.

“Many global custodians will be reliant on their third-party agent banks to perform the additional fiduciary duties,” said Merry.

“This means that custodians will need to have the local knowledge of each market and the infrastructure. Custodians with a large proprietary network will probably be more comfortable in offering enhanced protection,” he said.

Squire Patton Boggs’ Donnelly sees the question of depositary liability as part of a broader trend towards the increased oversight of service providers amongst those entrusted with fund governance. She sounds a note of warning about current standards and for trustees who fail to query the small print of client contracts.

“More and more, standards of care and the liability of the parties are a focus of attention at pension fund trustee meetings,” said Donnelly.

“Unfortunately, across the market there are still too many fund documents being signed that are completely unfit for purpose. Many investors don’t feel sufficiently empowered to negotiate the terms of contracts, but they are wholly negotiable,” she said.

The introduction of UCITS and AIFMD is creating a two tier level of protection for institutional investors, it can be expected that those that appear less protected will be monitoring the willingness of the industry to commit to the same level of protection.  It may be that the onus is on the asset owners to drive the global custodians towards offering the increased level of protection.