The reaction of the hedge fund industry to the final version of the Alternative Investment Fund Managers Directive (AIFMD) has understandably focused on distribution. After all, what matters most to hedge funds is their ability to raise capital to manage, and any restrictions on their ability to distribute their products to European investors are deeply unwelcome.

The at least temporary survival of the private placement regime allowing hedge fund managers to distribute BVI, Cayman and Guernsey-domiciled funds to European investors (with only a few additional reporting requirements) therefore came as a considerable relief. Coupled with the ability to distribute EU-regulated funds to anyone throughout the Union from 2015, and a period of dual running of the private placement regime alongside the third country “passport” for a further three years after that, it seemed that the worst fears of the industry were not realised. After all, 2018 is further ahead than most of us wish to plan.

But this sense of relief has shifted attention from operational aspects of the Directive which may impose some equally unwelcome constraints on the freedom of the industry to trade and invest as it wishes, let alone distribute wherever it wants. The requirement to use an independent valuation agent will not affect European funds, which all use third party administrators and fund accountants already. It is the insistence that funds use a third party depositary – that is to say, a custodian bank to safekeep the assets of the fund – that could well cause unforeseen problems for hedge funds distributing in Europe.

Third party custodianship is of course already happening. Until Bear Stearns stumbled and Lehman Brothers collapsed, hedge fund managers did not bother much with third party custody. Indeed, the economics of the hedge fund industry necessitated leaving assets of the fund in the custody of the prime brokers, who were permitted to re-hypothecate them up the Wazoo if they chose to do so. But since 15 September 2008 hedge fund managers have had to take seriously demands by their investors that they place unencumbered assets – those not being lent or used as collateral for financing – with a third party custodian.

This is why one hedge fund manager I spoke to recently felt able to dismiss the issue of third party custody under the AIFMD as simply “part of the cost of doing business.” This is to miss the point, which is that there is likely to be a shortage, if not a complete absence, of custodian banks willing to fulfil the depositary role at a price hedge fund managers are willing to pay. This is because regulatory and legal developments in Europe have alerted custodian banks to the likely nature and scale of the liabilities they would face as depositary banks to hedge funds distributed to professional and retail investors in Europe.

Autorité des Marchés Financiers (AMF), the French regulator, has already ordered two of the custodian banks acting as depositaries to hedge funds that used Lehman Brothers as a prime broker – Société Générale and RBC Dexia – to make whole investors who lost assets when the American investment bank collapsed. This order, which pre-empted the conclusion of bankruptcy proceedings, survived an appeal to the French courts. More importantly, it was allowed to stand despite the fact that the hedge fund managers had authorised Lehman as prime broker to re-hypothecate assets. Separately, both HSBC and UBS, as depositary banks to feeder funds which lost assets to the Madoff fraud, are engaged in prolonged litigation in Luxembourg over their level of responsibility for the losses which were incurred.

In this contentious, litigious and potentially expensive environment, a requirement under the AIFMD making depositary banks liable for any and all losses of financial instruments incurred by hedge fund managers, hedge funds and investors in hedge funds lacks appeal to custodian banks. True, the latest version of the Directive does not make depositaries liable for sub-custodian risk. But this is something custodian banks have rarely if ever assumed on behalf of long-only funds anyway, and which they will be reluctant to leave to the vagaries of the interpretation of the Directive by lawyers at the local level in any case.

Indeed, the Directive says a bank can only avoid liability for loss if it can prove that the loss has “arisen as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite its reasonable efforts.” That language implies a high level of liability. No wonder custodian banks are not exactly queuing up to take responsibility for losses over which they will inevitably have little or no “reasonable” control.

One likely outcome is that custodians will exit the business altogether. This will at best reduce the range of options for hedge funds, and raise the price of safe custody, by concentrating business with a smaller range of large institutions. Another possible outcome is that hedge fund managers distributing in Europe will find they cannot invest in certain asset classes, or must accept restrictions by the custodian over the uses to which assets can be put. This may be incompatible with certain investment strategies.

Imagine, for example, a custody contract that prevents the re-use of assets as collateral to secure financing from a prime broker, or as collateral in a securities loan or an OTC derivative transaction. It is not inconceivable that a custody contract ban investment altogether in certain jurisdictions (because of legal or infrastructural uncertainty) or asset classes (because it is too difficult to track the ownership or whereabouts of the assets). At worst, of course, there will be cases where no bank at all is willing to underwrite a risk at any price. At that point, distribution of some strategies to European investors will not be possible.

This issue is no longer a subject of discussion in terms of principle, as opposed to detail. The Directive is now part of European law. Over the next two years, down to early 2013, it will be “transposed” (as the Euro-jargon has it) into the national law of the various member-states of the European Union. The actual implementation will probably vary country by country as national regulators interact with the European Commission and the new European Securities and Markets Authority (ESMA, successor the Committee of European Securities Regulators, or CESR)

Family offices may have escaped the reach of the Directive, but all forms of alternative investment strategies – hedge, private equity, venture capital, real-estate and infrastructure funds – will be subject to the Directive, provided they are managing at least €100 million on an unleveraged basis or no more than €500 million on a leveraged basis.

But it is worth remembering that non-EU funds distributed in Europe will have to be in full compliance with the Directive. And there is already work in hand to ratchet up depositary liability in the UCITS funds which many hedge fund managers identified as a possible route round the AIFMD. This entire area is now polluted by political considerations – and what politicians want is an industry in which no retail investor-cum-voter is ever responsible for the consequences of his or her own decisions. That could mean that nobody else wants to take responsibility either.


Dominic Hobson is editor – in – chief of the Asset International title Global Custodian. Dominic is a published author, with three books – The Pride of Lucifer (Hamish Hamilton, 1990), Saturn’s Children (Sinclair – Stevenson, 1995), and The National Wealth (Harper Collins, 1999). He holds a degree in history from Magdalene College, Cambridge. He currently resides in London.