A crack team of financial industry representatives were invited to Paris by the European Securities Market Authority (ESMA) on 21 July to lay out the case for why asset segregation as proposed under the Alternative Investment Fund Managers Directive (AIFMD) and UCITS V would undermine collateral management, without bringing any of the investor protection it promised.
The European Central Bank, EU Commision, Association of Global Custodians and Association for Financial Markets in Europe, along with industry stakeholders, were all present to discuss the matter ahead of the 23 September deadline for ESMA’s call to evidence following its latest AIFMD/UCITS V consultation paper relating to this issue.
The large delegation in Paris heard from multiple industry representatives that AIFMD should adopt an optional asset segregation clause, similar to existing segregation rules such as the European Markets Infrastructure Regulation (EMIR). For example, Article 39 of EMIR requires central counterparties to offer individual client segregation and omnibus client segregation. Mandatory segregation would also make AIFMD inconsistent with the Markets in Financial Instruments Directive, along with a number of other existing regulatory frameworks.
Beyond the regulatory inconsistency, the industry appears united in its belief that demanding mandatory segregation for UCITS and alternative investment funds (AIFs), which both fall under AIFMD’s remit, would take a significant chunk of liquidity out the market by burdening the affected fund types with rules that would make them significantly less attractive to do business with, by eliminating their ability to offer intra-day collateral exchanges.
Ross Whitehill, managing director and head of strategic regulatory office and global collateral solutions at BNY Mellon, who was present at the meeting in Paris, comments: “To date, no one has been able to identify for and within the industry any benefit of segregating assets throughout the custody chain.”
“The regulators, we believe, understand that and have asked the industry delegation to come up with ways of improving investor protection and speedy return of assets.”
A problem shared
The negative consequences for day-to-day trading in a segregated environment versus the current system are laid out in Figures 1 and 2 overleaf. As shown in Figure 1, all assets are equal in that multiple fund types are able to contribute to a single asset pool, which can then be lent out collectively. In this example, XYZ Ltd is able to make a single transaction with the securities lending agent lender in exchange for a single portfolio of collateral, regardless of whether the securities it is borrowing came from one or more of the agent’s clients. If that collateral needs to be amended throughout the day, that would also only require a book entry transaction in the agent lender’s books and records.
Figure 2 shows a segregated environment where that same request for securities could potentially require several transactions to multiple accounts with collateral and securities being exchanged in a piecemeal fashion if the securities come from UCITS funds or AIFs, which creates new operational and settlement risk exposures for all relevant parties and becomes an administrative headache. Additionally, intra-day collateral substitutions would no longer be possible due the new requirement to physically shift assets from specific segregated accounts around the world.
At the same time, other fund types, such as sovereign wealth funds and pension funds, would still able to pool their resources in omnibus accounts, making it highly likely a borrower will request to use these securities from a single source in order to cut down on the admin required to complete the trade. The result is that UCITS and AIFs are likely to lose out on potential revenue due to the relative complexity of their custody arrangements. On top of all this, they may be asked by their custodian/agent lenders to pay for the privilege of having a segregated account, while receiving no, as yet identified, additional investor protection in return.
According to Whitehill, funds that aren’t AIFs or UCITS have an average portfolio penetration in securities financing of around 12 percent. For AIFs and UCITS, it’s around 7.7 percent, and while not solely attributable to the fear of segregation, where possible, borrowers are avoiding borrowing AIF/UCITS assets.
“In all probability these fund types [UCITS and AIFs] will have to adjust their benchmarks downwards in the event of mandatory segregation because they would have the additional expense of segregation and a performance drag through lower lending and repo revenues.”
Although this should not be considered the death knell for either UCITS or AIFs in securities lending industry, the inevitable performance drag could dissuade potential future investors that value securities lending as a revenue stream from allocating assets to those fund types.
Side effects assemble
Disincentivising the use of UCITS and AIF assets carries significant consequences for the lending market as a whole, but especially for the buy side, which will become increasingly reliant on what’s left of the pooled assets. In a single move, ESMA risks upending the current lending market environment from one where supply far outstrips demand to the reverse being true.
For the regulator, an over-reliance on sovereign wealth funds specifically should be a cause for concern because, for the most part, these entities are wholly outside of the remit of the EU and therefore not guided by its high regulatory standards. The funds that EU buy-side participants will be exposed to will likely be Asian and Middle Eastern in origin, both locations that are much more susceptible to ‘wobbles’ than their western counterparts. Middle Eastern sovereign wealth funds are intrinsically tied to the value of oil, which, given its current trajectory, mean that their high-quality liquid assets may become not so high-quality in the future, and leave EU borrowers with market exposures they are not equipped to manage.
According to the International Securities Lending Association’s (ISLA) latest report on the global securities lending industry, 44 percent of the total global lending pool is made up of assets from mutual funds, which are governed by UCITS in the EU. Despite being far and away the biggest contributor to the lendable pool, mutual funds only make up 18 percent of the on-loan balance.
According to IHS Markit, as of 28 July, UCITS funds accounted for just 4.7 percent of on-loan balances. In its report, which was published in March, ISLA stated that it is “likely that this reflects the restrictive regulatory environment applied to this sector in respect of securities lending”.
Meanwhile, sovereign wealth funds, which only account for 8 percent of available securities, make up a disproportionately high 13 percent of the total on-loan volume, according to ISLA. Insisting on mandatory segregation would go a long way to compounding this trend further. “Again, sovereign wealth funds (who only comprise of 8 percent of lendable securities) report a disproportionately high 13 percent of all securities on-loan.”
“Furthermore, potentially we could see on-loan balances from UCITS continue to decline as asset segregation rules previously applied under AIFMD are more broadly applied to UCITS.”
Once bitten, twice shy
Mandatory segregation of assets was originally conceived as a way of forming a new layer of investor protection and transparency that would allow for faster asset recovery in the case of an intermediary insolvency—but the industry has repeatedly highlighted the ineffectiveness of this approach.
The initial argument offered by regulators cited the collapse of Lehman Brothers and the subsequent seven-year saga that PwC, as the administrator of the failed bank’s assets, had to go through to return them to investors. However, BNY Mellon commissioned a letter from PwC, which was presented to ESMA at the Paris meeting, outlining why having segregated accounts wouldn’t have sped up the process.
Tony Lomas, a partner at PwC and the letter’s author, explained: “Even where there were accounts where there were no reconciliation breaks and both the Lehman Brother International Europe (LBIE) statement and sub-custodian statement were aligned, we could not begin to release those assets until we were certain that all of the other accounts were correct, on the basis that, in common with all business failure environments that I have experience of, we could not be sure of the accuracy of LBIE’s management information in the immediate aftermath of the collapse.”
“More specifically, whilst an insolvency practitioner must respect third-party rights to assets that are in the practitioners possession or under the practitioner’s control, the practitioner must satisfy themselves both that the claimant has undisputed legal title to an asset, that no other claimant has a competing claim against the same asset and that the insolvent entity itself doesn’t have a right to it.”
A second driver behind the regulator’s initial desire for segregation was a lingering fear of a repeat of the events around the 2008/09 Bernie Madoff scandal, where Madoff turned his wealth management firm into the world’s largest Ponzi scheme. Again, however, Madoff was the fund manager of Bernard L. Madoff Investment Securities and therefore had the authority to access funds throughout the firm, regardless of whether they were in a segregated or omnibus account, and that is still the case today.
Whitehill offers one explanation for why, given the weight of evidence in favour of optional segregation, ESMA is still entertaining the idea of making it mandatory.
“AIFMD probably started to be drafted before EMIR, and when it was being put together it was shortly after the crash and in response to Madoff,” he explains.
“Physical segregation of assets in most respects is old thinking, given that markets are mostly electronic today. When the legislation was being drafted we believe that only the impact on custody was considered. No-one thought about triparty collateral management, financing or securities lending and the impact segregation would have on funding and liquidity.”
“The latest meeting was the first time we’ve had everyone who is relevant to the discussion in the room. Previously we’ve held such meetings bilaterally. The very positive thing is that all of the national competent authorities and ESMA are listening, are keen to get the rules right, and are willing to do something about it.”