ESMA’s Asset Segregation Debate: More than a Custody Issue

ESMA’s proposal for full account segregation doesn’t necessarily fix the problem of timely investor restitution and could have broader implications for the asset management industry.

Most people in the asset management arena are at least broadly aware of the new depositary regime introduced by AIFMD and UCITS 5. These regulations have significantly strengthened depositary liability standards and operating models for European funds. However, what many may not realize is that there will be ongoing changes to European depositary rules.

ESMA and the industry remain in active dialogue on the optimal common asset segregation regime. In July 2016, ESMA published a Call for Evidence – Asset Segregation and Custody Services and on 27 September the industry responded.

The issues at hand are quite technical but, in summary, ESMA contends that investor assets are best protected if their assets are held in fully segregated accounts in their own name throughout the entire custodial chain rather than within omnibus accounts. An omnibus account is a securities account opened at a sub-custodian or a Central Securities Depository in the name of an account provider (a depositary/custodian) where the securities may belong to several underlying clients. The account provider also maintains their own independent books and records of assets are held for each individual investor.

The custodian and asset management communities both strongly contend that implementation of this level of segregation would in fact result in reduced efficiencies, increased risk and cost, and in practical terms actually result in a worse situation for investors. Regardless of its conclusion, those closest to the Lehman’s case have publicly stated that it was the firm’s poor internal recordkeeping as well as the highly fragmented global insolvency law framework that created delays and difficulties for liquidators. Account segregation was actually a relatively insignificant issue within the liquidation process. Given that those legal complexities still exist, any similar insolvency today would be negligibly impacted by holding securities omnibus or fully segregated in markets, so ESMA’s proposal doesn’t necessarily fix the problem of restitution of investor assets in a timely fashion.

Whilst primarily being viewed as a depositary issue, the implications of segregation have wider industry impacts. Beyond the obvious custodial issues, there are two ways the wider industry may be affected.

Collateral Arrangements

Many EU domiciled funds use short-term financing arrangements, such as repo transactions and securities lending, to enhance their yields. These transactions by nature are underpinned by very frequent (multiple intraday) exchanges of securities collateral between the collateral giver and taker with a tri-party collateral agent usually in the middle for efficiency. Account segregation fragments EU funds’ collateral pools, creating reduced efficiency since collateral flows, optimization, and substitutions have to occur at market level rather than internally. Further, the inability to net collateral transactions within omnibus accounts results in a significant increase in the amount of external market securities movements needed. This slows down transaction times and increases trade breaks, which in turn reduces market liquidity and increases the cost and complexity of such transactions. With the high frequency of collateral movements required it would be difficult for the existing market infrastructure to handle the volume and complexity of these trades.

This could force EU funds and their counterparties into bilateral collateral arrangements in which counterparty, credit, settlement, and operational risk would be increased. This goes against the macroprudential goal of clearing these transaction types through central repositories and could dampen EU funds returns through decreasing attractiveness of securities loans and repo transactions.

Regulatory Conflicts

The other potential issue with the proposals is that they conflict with a host of other regulations.

Global Standards
Whilst the requirements here are limited to EU regulated funds, these funds normally invest in markets beyond EU borders. Imposing European specific asset segregation rules on global holdings would bifurcate the required custody model into an EU funds model and everything else. Essentially every custodian would need to run two sets of books and records with distinct operational processes for EU funds and everything else.

Other European Regulations
The favored segregation model of ESMA is ironically inconsistent with the principles contained in regulations such as T2S, EMIR, MiFID 2, and CSDR amongst others. For example, the primary goal of T2S is to harmonize market infrastructure to increase liquidity and reduce risk and cost. Account fragmentation would completely hamper these goals.

In addition, any fragmentation of asset/liquidity pools reduces the markets’ ability to mobilize and optimize collateral to reduce counterparty exposures. Counterparty risk reduction is the primary goal of EMIR. Such segregation also results in clearinghouses having fewer eligible assets capable of being netted. Netting is a key factor in reducing OTC credit risk and exposures and without it the benefits of central clearing enshrined in both EMIR and Dodd-Frank rules may not be possible.

In conclusion, whilst industry has spoken, the final decision remains in ESMA’s hands.  It is expected that ESMA will formally opine before the end of 2016, but this is not set in stone.  The debate could conclude in retention of the status quo, but could also result in mandated account segregation for EU Funds, which would require a detailed review of custody operational models and all collateral-related activity within EU funds. This would represent a seismic shift for trillions of dollars of global assets and is definitely something for asset managers to keep an eye on.