Regulation Tomorrow: Asset Management Series - The Role Of Depositaries

Hello and welcome to the third in our series of Regulation Tomorrow podcasts on the future of asset management regulation in the UK. My name is Anita Edwards and I'm a Senior Knowledge Lawyer here at Norton Rose Fulbright in London. Today I am joined by Hannah Meakin, a partner in our Financial Services team, and Associate Taher Ahmed - and we are going to talk about the role of depositaries in UK asset management.

In its recent discussion paper, DP23/2, on the future of the UK asset management regime, the FCA discussed the important function played by depositaries in ensuring the assets of a fund are appropriately protected, and in overseeing the activities of the fund manager. However, it also flagged its concerns around how some depositaries actually perform those functions in practice, and it suggested various ways of updating its rules relating to depositaries and making them clearer.

Before we talk about the FCA's concerns, and its proposals to address them, Taher perhaps you could just give us a quick overview of the role that depositaries play in the asset management context?

Yes of course, thanks Anita and hello everyone.

So a depositary of a fund is usually appointed by the fund manager to carry out certain functions, including the safekeeping of the fund's assets, monitoring the fund's cash flows and overseeing the activities of the fund manager. The detail of the depositary's responsibilities does differ depending on whether the fund is authorised or not, but broadly those are the functions a depositary carries out.

Just to note here, the role of a depositary is broader than that of a custodian. A depositary acts as safekeeper of the fund's assets and this is what a custodian would also do - in fact, depositaries can delegate this function to a custodian subject to certain conditions. But that is just part of the depositary's role - as well as the safekeeping side of things, it also monitors the lawfulness of the fund's and the fund manager's activities.

The purpose of having a depositary is to ensure that investors are protected from harm. Depositaries are required to maintain records of assets (i.e., book entries) for transactions which are effected by the fund's manager for the benefit of the fund's investors/unitholders. The depositary essentially acts as a guardian for the fund's investors/unitholders to ensure the fund's manager is held accountable, not misappropriating assets and complying with the necessary rules.

The oversight function of a depositary is the one that has received the most attention from the FCA over the years. The depositary is required to oversee how the manager manages the fund, to check that it's acting in line with the relevant rules and in accordance with the fund prospectus. That includes monitoring what the fund can invest in, and also monitoring the pricing and dealing in units of the fund.

Depositaries obviously need to have robust systems and controls in place to enable them to carry out those monitoring responsibilities and to ensure they can identify any breaches. And in carrying out their role, they are required to act honestly, fairly, professionally, independently and solely in the interest of fund investors.

Thanks Taher. It's clear that depositaries play an important role in safeguarding not just the assets of a fund but also investors' interests more broadly. Given its importance, that role has come under FCA scrutiny in recent times, and as you mentioned, the FCA has raised some concerns around the level of oversight that is actually being provided by depositaries in practice. Hannah, could you talk us through some of those concerns?

Yes - thanks Anita.

Back in 2017, the FCA carried out a review of property fund suspensions and pricing adjustments in the aftermath of the Brexit vote, and as part of that review it looked at how firms - including depositaries of authorised funds - fulfilled their oversight role. The FCA found that depositaries seemed to provide an effective, independent check of authorised fund managers' compliance with the COLL sourcebook under normal market conditions. However, its findings also suggested that firms didn't seem to have considered fully how they should meet their responsibilities under stressed market conditions.

More recently, in March 2022, the FCA raised its concerns again in a Dear CEO letter that it sent to firms in the custody and fund services sector. In the letter, it noted that this was one of the principal areas of potential harm to clients and end-consumers, and to market integrity, and it reminded firms of the important role depositaries play in overseeing the activities of managers of authorised funds.

However, the FCA explained that it was continuing to see weaknesses in depositaries' oversight and often an absence of effective challenge of the fund manager, which can lead to potential harm to unitholders and investors. It also raised concerns about the robustness of controls used by depositaries to oversee fund liquidity and investment and borrowing limits - it said it had seen examples of a lack of holistic judgements in these areas, including a narrow interpretation of the applicable COLL rule that requires a 'prudent spread of risk', and a lack of policies or procedures related to it.

And this year, in DP23/2, the FCA has again flagged its concerns with the oversight being exercised by some of the depositaries in the market. It said that depositaries have not always intervened or challenged fund managers and that they don't always achieve effective outcomes when conducting their oversight duties. The FCA also noted that depositaries' own interpretations of the rules that apply to them can sometimes differ from the FCA's supervisory expectations. And to complicate things further, the requirements that apply to depositaries also differ depending on the category of fund.

Thanks Hannah. And as you mentioned, given the important function played by depositaries, this is one of the areas the FCA is looking to address with some of its proposals in DP23/2. As we have discussed in our previous asset management podcasts - which are available on our website for anyone who hasn't listened to them yet - the FCA has set out various ideas in DP23/2 for reforming the UK asset management regime, although not all of them will actually be taken forward. Given that the FCA has said it will be guided by feedback it receives to the DP as to which proposals it should pursue, the changes relating to depositaries could go ahead if there is enough backing for them.

Taher, maybe you could run us through what changes the FCA is proposing in relation to its rules around depositaries?

Yes sure, thanks Anita.

So the FCA explains in the discussion paper that it sees potential benefit in updating and clarifying its rules in this area. And as part of that, it is considering making its expectations of depositaries clearer in a number of areas, which include:

• the systems and controls a depositary has to have in place to identify breaches of the rules and the constitutional documents of a fund;
• the resources, knowledge, skills and experience that are expected of a depositary;
• the actions the FCA expects to be taken when a breach is identified;
• what the depositary should do if the fund manager doesn't take action to deal with a breach;
• the depositary's oversight of the authorised fund manager's liquidity management (including liquidity stress testing); and
• how the depositary oversees the authorised fund manager's pricing and dealing in units of the fund.

The discussion paper also asks for views on whether there are any areas where the FCA's rules require depositaries to carry out oversight functions that are of limited benefit, and so should be removed. Although just to note that the industry is also being asked to flag areas where the contribution of depositaries is particularly valuable for the interests of investors, and so the oversight function should remain in place.

Thanks Taher. We'll have to wait and see whether any of these proposals are taken forward after the discussion paper has closed for comments on the 22nd of May. In the meantime, it is worth also briefly touching on the still relatively new Long Term Asset Fund, or LTAF, and the role depositaries are required to have in relation to those funds. The FCA's LTAF rules relating to depositaries have also faced some criticism recently.

Now, the FCA's new rules to introduce the LTAF came into force from the 15th of November 2021 and they created a new category of authorised fund - the LTAF - which is intended to enable a wider range of investors to access long-term illiquid assets but with rules in place to address the specific risks these assets pose.

Hannah, please could tell us a bit about the role of the depositary in relation to the new LTAF?

Of course. So as you mentioned, LTAFs predominantly hold long-term illiquid assets such as real estate and because of the risks involved in holding those assets, the depositary of an LTAF has some additional responsibilities. Now, the LTAF is an alternative investment fund so the usual rules for depositaries managing an AIF as set out in UK AIFMD are applicable. Additionally, COLL 15 sets out the parameters of what an LTAF can and cannot invest in, including more detailed rules on the investment guidelines and restrictions that it needs to adhere to.

Some of the further responsibilities that a depositary of an LTAF has include overseeing the fund manager where the manager is permitted to value the LTAF's assets itself without appointing an external valuer. This won't always be the case, as for the fund manager to perform the valuation responsibilities in-house, it is required to show it has the competence and experience to value these types of assets, otherwise it must appoint an external valuer. The depositary is responsible for determining whether the manager has the skills, resources and procedures needed to carry out these valuations.

There is also a requirement in COLL 15 for the depositary of an LTAF to take legal ownership/custody of all of the assets of the LTAF that are in registered form. There has been quite a lot of criticism around this requirement within the industry, on the basis that it is impractical to require depositaries to hold legal title to all of the illiquid assets that an LTAF invests in. By requiring depositaries to hold legal title to all assets in registrable form it creates a significant administrative burden, as depositaries are required to go further than the standard verification of ownership for these types of non-financial instruments and must take affirmative steps to ensure legal title is registered in their name.

When the FCA consulted on its proposals for the LTAF, some of the depositaries and fund managers that responded to the consultation suggested an alternative model, where the assets would be legally owned by the fund itself (if it has legal personality) or by the fund manager on the fund's behalf.

The FCA acknowledged the difficulties involved in requiring depositaries to legally own the illiquid assets in the LTAF, but said it would need to consult in the area as changing that rule would have potential implications for other categories of authorised funds such as property funds. No consultation has been published on this point as yet, but in the meantime, if a firm wants to set up an LTAF it can apply to the FCA to modify or waive this requirement on the basis of the fund having alternative custody arrangements. The FCA encourages firms to communicate with it before submitting a formal request to modify or waive.

Thanks Anita. We are definitely seeing more LTAFs being formed, and the first one got approved by the FCA earlier this year in March. It will be interesting to see how the FCA works in any reforms to the LTAF regime given how recently LTAFs were introduced. For example, the impracticality and administrative burden of requiring all assets to be held in custody as Hannah mentioned is causing commotion across the markets for depositaries, with many having to restructure their usual business operations to account for legal title transfers of illiquid holdings that are non-financial instruments.

There is also the potential for LTAFs to be extended to include retail clients. At the moment the rules only allow professional or sophisticated investors to invest in an LTAF but the FCA published a consultation paper in August 2022, CP22/14, which recognised that there may be investor appetite for retail investors who seek out non-traditional investments in search for diversification or higher returns. Clearly, broadening the target market for such funds to include retail clients will put depositaries in the spotlight even more given the FCA's continued focus on protecting consumers - the Consumer Duty being a prime example. If LTAFs are extended to the retail market, we expect there to be heightened scrutiny of depositaries by the regulator to ensure they are fulfilling their oversight duties to protect consumers from harm.

Thanks Taher - and thanks Hannah - for your insights today.

Please look out for more updates on the future of the UK asset management regime and other topics on our Regulation Tomorrow blog. If you would like to discuss anything we have covered today, please get in touch with one of us and we would be happy to help.

Thank you for listening.